A Comprehensive Guide to ASC 842 Lease Accounting

Introduction

Imagine you’re playing a game of Monopoly where you have to keep track of everything you borrow and lend, without keeping any written data. Now, think of a company doing the same thing but on a much larger scale – it can be disastrous! This is where ASC 842 comes in. ASC 842 is a set of rules that tells companies how to report their leases, things like rented buildings, vehicles, or equipment on their financial statements. It might sound complicated, but understanding these rules is crucial for businesses to keep everything transparent and fair.

In this guide, we’ll explore what ASC 842 is, how it changes lease accounting, look at how to record lease entries, and avoid common pitfalls. By the end, you’ll have a solid understanding of ASC 842 and how it helps companies stay on top of their game.

What is ASC 842?

ASC 842 is an accounting standard issued by the Financial Accounting Standards Board (FASB) that dictates the treatment of leases in accounting. It requires companies to report leases longer than twelve months as assets or liabilities on their balance sheets, enhancing transparency in financial reporting.

ASC 842 changed the way companies account for leases, making them more visible in financial statements. Previously, many leases were kept off the balance sheet, meaning they weren’t always clear to investors or stakeholders.

The goal of ASC 842 is to improve transparency and comparability among organizations by ensuring that lease obligations are reflected more accurately in financial statements. It also brings U.S. standards more in line with international standards, specifically IFRS 16. This global alignment helps multinational companies streamline their accounting processes and provides a more consistent view of financial health across different jurisdictions.

Key components of ASC 842 lease accounting

Right-of-use (ROU) asset: This asset represents the lessee’s right to use an underlying asset for the lease term. Its value is determined by considering the present value of lease payments, adjusted for any initial direct costs, lease incentives received, and any prepaid or accrued lease payments.

Lease liability: This liability reflects the obligation to make lease payments over the lease term. It’s calculated as the present value of the lease payments, discounted at the rate specified  in the lease or, if that rate cannot be readily determined, the lessee’s incremental borrowing rate.

Transition to ASC 842

Transitioning to ASC 842 involves a significant shift in how leases are accounted for and reported. Companies must evaluate all existing leases to determine the necessary adjustments for compliance. This process includes:

1. Identifying all leases: Companies need to review all contracts to identify which ones contain leases as defined by ASC 842.
2. Calculating the ROU asset and lease liability: For each lease, companies must calculate the ROU asset and lease liability and record these on the balance sheet.
3. Implementing new processes: Companies may need to update their accounting systems and processes to handle the ongoing requirements of ASC 842, such as periodic measurements and disclosures.

What are the Two Types of Leases Under ASC 842?

ASC 842 classifies leases into two main categories: finance leases and operating leases. Each type of lease has distinct accounting treatments and implications for financial reporting.

Finance leases

A finance lease, previously known as a capital lease, is essentially treated as a purchase of an asset. Under ASC 842, a lease is classified as a finance lease if it meets any one of the following criteria:

1. Ownership transfer: The lease transfers ownership of the asset to the lessee by the end of the lease term.
2. Purchase option: The lease grants the lessee an option to purchase the asset, and it is reasonably certain that the lessee will exercise this option.
3. Lease term: The lease term covers the majority of the remaining economic life of the asset.
4. Present value: The present value of the lease payments equals or exceeds substantially all of the fair value of the asset.
5. Specialized asset: The asset is of such a specialized nature that it has no alternative use to the lessor at the end of the lease term.

Operating leases

Operating leases are leases that do not equate to purchasing assets. These are leases where typically the lessee uses the asset for a portion of its useful life, and there is no transfer of ownership or option to purchase the asset. Under ASC 842, a lease is classified as an operating lease if it does not meet any of the criteria for a finance lease.

1. No Ownership Transfer: The lease does not transfer ownership of the asset to the lessee by the end of the lease term.
2. No Purchase Option: The lease does not grant the lessee an option to purchase the asset, or if it does, it is not reasonably certain that the lessee will exercise this option.
3. Lease Term: The lease term is not for the majority of the remaining economic life of the asset.
4. Present Value: The present value of the lease payments does not equal or exceed substantially all of the fair value of the asset.
5. Non-Specialized Asset: The asset is not of such a specialized nature that it has no alternative use to the lessor at the end of the lease term.

Key differences between finance and operating leases

Aspect	Finance Lease	Operating Lease
Expense Recognition	Separate interest and amortization expenses	Single lease expense on a straight-line basis
Impact on Financial Ratios	Higher initial expenses due to front-loaded interest and amortization, impacting profit margins and other financial ratios	Evenly distributed expenses over the lease term, providing a smoother expense pattern
Income Statement	Recognition of interest expense and amortization of ROU assets	Recognition of single straight-line lease expense
Cash Flow Statement	Principal payments in financing activities and interest payments under operating activities	Lease payments for operating activities

What are the ASC 842 Journal Entries?

Under ASC 842, companies need to record journal entries to reflect lease assets and corresponding lease liabilities on their balance sheets. The journal entries differ depending on whether the lease is classified as a finance lease or an operating lease.

1. ASC 842 Journal Entry for Finance Leases

   Finance leases, previously known as capital leases, are treated similarly to the purchase of an asset. Here are the typical journal entries for finance leases under ASC 842:

   1. Initial recognition:

   At the start of the lease, record the ROU asset and the lease liability at the present value of the lease payments. For example, if the present value of the lease payments is $100,000 the journal entries will be as follows::

   • Debit the ROU asset for $100,000 to show that the company now has the right to use an asset.
   • Credit the Lease liability for $100,000 to reflect the obligation to make future lease payments.

   This entry ensures that both the asset and the liability are accurately reflected on the balance sheet.

   2. Subsequent measurements

   Each month, you’ll need to account for the interest on the lease liability and the amortization of the ROU asset. For instance, if the monthly interest expense is $833 and the monthly amortization expense is $1,667  the journal entries will be as follows:

   • Debit Interest expense for $833 to reflect the cost of borrowing.
   • Credit Lease liability for $833 to reduce the lease liability by the interest amount.
   • Debit Amortization expense for $1,667 to allocate the cost of the asset over its useful life.
   • Credit Accumulated amortization for $1,667 to decrease the value of the ROU asset.

   These entries ensure the ongoing recognition of interest expenses and the amortization of the asset.

2. ASC 842 Journal Entry for Operating Leases

   1. Initial recognition

   Similar to finance leases, at the start of an operating lease, record the ROU asset and the lease liability at the present value of the lease payments. For example, if the present value is $100,000 the journal entries will be as follows:

   • Debit the ROU asset for $100,000 to reflect the right to use the asset.
   • Credit the Lease liability for $100,000 to show the obligation to make future payments.

   This ensures that the lease is properly recorded on the balance sheet.

   2. Subsequent measurements

   Each month, record a single lease expense that spreads the cost evenly over the lease term. For example, if the monthly lease expense is $2,500 the journal entries will be as follows:

   • Debit Lease expense for $2,500 to reflect the cost of using the leased asset.
   • Credit Lease liability for $2,500 to reduce the lease liability by the lease payment amount.

   This straightforward entry ensures that the lease cost is recognized consistently throughout the lease term.

ASC 842 journal entry example:

By understanding and applying these journal entries, companies can ensure compliance with ASC 842, providing clear and accurate financial reporting for their leases. This enhances transparency and helps stakeholders better assess the company’s financial health.

How Do You Record an ASC 842 Journal Entry for a Lease?

Recording an ASC 842 journal entry for a lease involves several steps to ensure that both the right-of-use asset and the lease liability are accurately reflected on the balance sheet. Here’s a step-by-step guide to help you understand the process:

Step 1: Identify the lease components

Before recording any journal entries, identify the lease components and categorize lease and non-lease components if applicable. This includes the lease payments, initial direct costs, and any lease incentives.

Step 2: Measure the lease liability

The lease liability is measured at the present value of the lease payments that are not paid at the commencement date. To calculate the present value, use the interest rate specified in the lease, if readily determinable. If not, use the lessee’s incremental borrowing rate.

Lease liability calculation:

• Lease payments (fixed payments, variable payments based on an index or rate, residual value guarantees, purchase options, termination penalties)
• Discount rate (interest rate implicit in the lease or incremental borrowing rate)

Step 3: Measure the right-of-use asset

The ROU asset is initially measured at the amount of the lease liability, adjusted for lease payments made at or before the commencement date, initial direct costs, and any lease incentives received.

ROU asset calculation:

• Lease liability (from Step 2)
• Plus: Lease payments made at or before the commencement date
• Plus: Initial direct costs incurred by the lessee
• Less: Any lease incentives received

Step 4: Record the initial journal entry

At the lease commencement date, record the initial journal entry to recognize the ROU asset and the lease liability.

Here is an ASC 842 lease accounting example for better understanding.

Initial journal entry:

Debit: ROU asset by $100,000

Credit: Lease liability by $100,000

Step 5: Subsequent measurements and journal entries

For each subsequent period, record the lease expenses and update the lease liability. The process differs between finance leases and operating leases.

Finance Leases:

Record interest expense on the lease liability and amortization expense on the ROU asset.

Example Journal Entries (Finance Lease):

• Debit: Interest expense by $833
• Credit: Lease liability by $833
• Debit: Amortization expense by $1,667
• Credit: Accumulated amortization by $1,667

Operating Leases:

Record a single lease expense on a straight-line basis over the lease term.

Example Journal Entries (Operating Lease):

• Debit: Lease expense by $2,500
• Credit: Lease liability by $2,500

Step 6: Reassess and remeasure lease components

Periodically reassess and, if necessary, remeasure the lease liability if there are changes in lease terms, lease payments, or the lessee’s discount rate. This ensures that the financial statements accurately reflect the current lease obligations.

By following these steps, companies can accurately record and maintain their lease obligations under ASC 842, ensuring transparency and compliance in their financial reporting. This detailed approach helps stakeholders gain a clearer understanding of a company’s financial health and commitments.

Special Considerations for Short-Term Leases

Under ASC 842, short-term leases are those with a lease term of 12 months or less and no purchase option that the lessee is reasonably certain to exercise. These leases have a simplified accounting treatment that eases compliance.

Accounting treatment

ASC 842 allows an optional practical alternative for short-term leases. If selected, this alternative allows lessees to recognize lease payments as expenses over the lease term, without the need to to recognize a ROU asset or lease liability. 

Example journal entry for short-term lease payments:

• Debit Lease expense: $1,000 (monthly lease payment)
• Credit Cash/Bank: $1,000

This entry records the lease payment as an expense, simplifying the accounting process.

Benefits of the practical alternative

• Simplification: Avoids the complexity of recognizing and measuring ROU assets and lease liabilities.
• Efficiency: Saves time and resources by streamlining the accounting process.
• Flexibility: Reduces the administrative burden for managing short-term leases.

Disclosure requirements

Even if the companies select the practical alternative,companies must disclose:

• The total lease expense for short-term leases.
• The selection of the practical expedient.
• Significant terms and nature of the leases.

These disclosures ensure transparency and provide necessary information to financial statement users.

By using the practical alternative for short-term leases under ASC 842, companies can simplify their lease accounting while maintaining compliance and transparency in financial reporting.

Impact of ASC 842 on Financial Statements

The implementation of ASC 842 has significant implications for a company’s financial statements. This section outlines the key impacts on the balance sheet, income statement, and cash flow statement.

Balance sheet

Under ASC 842, companies must recognize almost all leases on their balance sheets. This means recording both a right-of-use asset and a lease liability for operating and finance leases. The impact includes:

• Increased Assets and Liabilities: The recognition of ROU assets and corresponding lease liabilities will significantly increase the reported total assets and total liabilities.
• Changes in Asset Composition: The inclusion of ROU assets may alter the composition and ratios related to property, plant, and equipment.
• Debt-to-Equity Ratio: The addition of lease liabilities can affect leverage ratios, potentially impacting covenants and borrowing capacity.

Income statement

ASC 842 changes how lease expenses are recognized in the income statement, depending on whether the lease is classified as a finance lease or an operating lease.

• Finance Leases: Interest expense on the lease liability and amortization expense of the ROU asset are recorded separately. This often results in higher expenses in the earlier years of the lease.
• Operating Leases: A single lease expense is recognized on a straight-line basis over the lease term, which tends to smooth out the expense over time.

Cash flow statement

The classification of lease payments in the cash flow statement is also affected by ASC 842:

• Finance Leases: Principal repayments are classified as financing activities, while interest payments are classified as operating activities.
• Operating Leases: All lease payments are classified as operating activities.

Overall financial ratios

The changes brought by ASC 842 can affect various financial ratios such as:

• Leverage Ratios: Increased liabilities may impact debt-to-equity and other leverage ratios.
• Profitability Ratios: The timing and nature of expense recognition can affect operating income and net income, impacting profitability ratios.
• Liquidity Ratios: Changes in the classification of lease payments can influence cash flow-based ratios.

Investor and stakeholder perception

The increased transparency from recognizing lease liabilities and ROU assets enhances the clarity of a company’s financial obligations. This can lead to more informed decision-making by investors and other stakeholders.

In summary, ASC 842 significantly impacts financial statements by bringing most leases onto the balance sheet, changing the way lease expenses are recognized, and altering the classification of lease payments in the cash flow statement. These changes improve transparency and provide a more accurate picture of a company’s financial health.

Common Challenges and Pitfalls in ASC 842 Implementation

Implementing ASC 842 can be complex, and companies often encounter several challenges and pitfalls. Understanding these issues can help businesses prepare and navigate the transition more smoothly.

1. Identifying all leases

One of the initial challenges is identifying all lease agreements, including embedded leases within service contracts. Many companies underestimate the time and effort required to comprehensively review all contracts to determine which ones qualify as leases under ASC 842.

Pitfall: Missing out on embedded leases can lead to incomplete financial reporting and non-compliance with ASC 842.

Solution: Conduct a thorough review of all contracts and consult with legal and accounting professionals to identify embedded leases.

2. Data collection and management

Gathering the necessary data for each lease, such as payment schedules, lease terms, and discount rates, can be overwhelming. Inconsistent or incomplete data can hinder accurate accounting and reporting.

Pitfall: Inadequate data collection can result in errors and an increased workload during the audit process.

Solution: Implement robust data management systems and processes to ensure all required lease information is accurately collected and maintained.

3. Selecting the discount rate

Determining the appropriate discount rate for measuring lease liabilities is a common challenge. 

Pitfall: Using an incorrect discount rate can lead to significant inaccuracies in the measurement of lease liabilities and ROU assets.

Solution: Develop a clear policy for determining discount rates and ensure consistency in their application.

4. System and process changes

ASC 842 requires significant changes to accounting systems and processes. Many existing systems are not equipped to handle the new requirements, necessitating upgrades or replacements.

Pitfall: Delayed or inadequate system upgrades can result in non-compliance and increased manual workload.

Solution: Invest in an accounting software that complies with ASC 842 and integrate it with existing systems to streamline processes.

5. Training and change management

Ensuring that accounting and finance teams understand the new standard and its implications is crucial. Without proper training, there is a risk of misinterpretation and incorrect application of ASC 842.

Pitfall: Insufficient training can lead to errors in lease accounting and financial reporting.

Solution: Provide comprehensive training programs for all relevant staff and continuous support to address any questions or issues.

6. Ongoing compliance and monitoring

ASC 842 is not a one-time implementation but requires ongoing compliance and monitoring. Changes in lease terms, renewals, and modifications must be accounted for correctly.

Pitfall: Failing to monitor and update lease information regularly can lead to inaccuracies and non-compliance.

Solution: Establish processes for regular review and updating of lease data, and ensure continuous monitoring for any changes.

Implementing best practices and leveraging technology can help companies ensure a smoother transition to ASC 842 and ensure ongoing compliance with the new accounting standard for lease recognition.

How HighRadius Can Help Your Business Be Audit Ready

Implementing ASC 842 brings significant changes to lease accounting, requiring meticulous tracking and reporting of lease-related data. Highradius offers robust Record-to-Report solutions to help businesses manage these requirements efficiently, ensuring they remain audit-ready and compliant. Leveraging Highradius’ Financial Close Management software businesses can utilize the Close Checklists module, ensuring that all necessary documents, weblinks, and comments for ending balances are readily available for audits. This system of support documents not only boosts analyst productivity but also guarantees that backup documentation is always on hand, streamlining the audit process and ensuring compliance with ASC 842.

The Maker Checker Workflow is another critical tool for maintaining control over lease accounting tasks. This customizable task approval workflow allows companies to add multiple levels of approval based on the nature and potential impact of each task. By implementing a system where the work of one accountant is reviewed and approved by another, businesses can significantly reduce errors and ensure that all items are thoroughly reviewed. This workflow reduces the days required to close by 30%, helping businesses maintain the stringent control needed for ASC 842 compliance.

Highradius’ LiveCube Task Automation enhances efficiency by automating data extraction and facilitating period-over-period rollover with a single click. This minimizes manual intervention, reducing the scope for errors and freeing up time for analysts to focus on critical tasks such as audit preparedness, adjustments, and reporting. By streamlining these processes, LiveCube Task Automation accelerates the completion of close activities, making the entire process more efficient and reliable, which is crucial for meeting ASC 842 standards.

The Journal Entry Management module ensures accountability and integrity in journal entry postings. This tool meticulously maintains a detailed trail of records, including transaction details, dates, times, and user information. This ensures that all tasks worked on by preparers and approvers are logged for audit purposes and SOX compliance. Additionally, the tool seamlessly adapts to all ERPs and accounting software, supporting auto-posting to ERP or any other system of records. Further, the journal entries (JEs) can be customized based on system records, prepared manually using templates, or auto-populated in LiveCube. Custom JE posting workflows ensure compliance and streamlines the process. This meticulous logging and flexibility in journal entry preparation are essential for providing a clear audit trail and enhancing transparency in the audit process, particularly for maintaining compliance with the detailed requirements of ASC 842.

Through these features, Highradius supports businesses in achieving a streamlined, compliant, and audit-ready lease accounting process.

FAQs

1) When did ASC 842 become effective?

The ASC 842 became effective for public companies for fiscal years beginning after December 15, 2018. For private companies, it became effective for fiscal years beginning after December 15, 2019. This marked a significant shift in lease reporting on financial statements. 

2) How to calculate lease liability under ASC 842?

To calculate the lease liability under ASC 842, determine the present value of future lease payments. Discount the lease payments using the interest rate implicit in the lease, or if not readily determinable, the lessee’s incremental borrowing rate. Through this process, you’ll get the exact value of your lease liability.

3) When did ASC 842 become effective for private companies?

ASC 842 became effective for private companies for fiscal years beginning after December 15, 2019. This allowed private companies additional time to comply with the new lease accounting standard, ensuring they report leases on their balance sheets. They received an additional year compared to public companies.

4) How does ASC 842 affect cash flow statements?

Under ASC 842, finance lease payments are split between principal and interest. Principal repayments are shown under financing activities, while interest payments are under operating activities. Operating lease payments continue to be classified as operating activities.

5) Is equity affected under ASC 842?

Equity is not directly affected under ASC 842. The recognition of lease liabilities and right-of-use assets impacts the balance sheet but does not directly change equity. However, changes in reported expenses and liabilities can indirectly affect financial ratios and perceived financial health.

6) What is ASC 842 lease accounting?

ASC 842 lease accounting is the updated standard that requires companies to include all significant lease agreements on their balance sheets. This means companies must recognize and record leases as assets and liabilities, which was not always the case under previous standards.