Accounting for Leases- ASC 842

Accounting Standards Codification (ASC) 842, Leases, is effective for private companies and other not-for-profit entities that have not issued (or made available for issuance) financial statements that reflect the new standard as of June 3, 2020, are required to adopt the new leases standard for annual periods beginning after Dec. 15 and interim periods in annual periods beginning after Dec. 15, 2022. Early adoption is permitted for all entities. This is expected to have a significant impact on most entities’ balance sheets, considering how prevalent and routine leasing is to most businesses. The FASB issued the new standard to increase transparency and comparability among entities by recognizing leases on the balance sheet and providing more information about leasing arrangements so that users can assess the amount, timing and uncertainty of cash flows from leases. ASC 842 allows for two transition methods upon adoption:

? Modified retrospective transition approach: ASC 842 is applied to any leases existing at the beginning of the earliest comparative period presented in the financial statements, as well those commencing after that date, but prior to the effective date, with prior periods being restated; or

? Prospective transition approach: ASC 842 is applied only in the year of adoption, whereby the company would not need to apply the new guidance to its leases in the prior comparative periods. Public companies have already adopted the new standard and, based on the feedback and discussions in the past two years, it’s understood that adopting the new lease standard can be quite complex and time consuming, with many important nuances that can impact the amounts initially recorded.

As entities prepare for adoption of the standard and related year end reporting, they may want to consider the following steps related to ASC 842 implementation.

1. Project plan (including need for resources)
2. Existing process and controls
3. Service contracts or embedded leases
4. System implementation or implement a checklist.
5. Develop new accounting policies.
6. Debt covenants
7. Auditor involvement

Refer article link-California CPA - October 2021 (calcpa.org) for detailed discussion on each of these steps.

Lease Identification: It’s more important to determine whether a contract is a lease or contains a lease under the new leases standard than it was under ASC 840, as an incomplete population of leases (as discussed later in this article) could materially misstate financial results. Under ASC 842, lessees must recognize a right-of-use asset (ROU) and lease liability on their balance sheets for most leases.

Entities will need to apply judgment to determine whether the contract includes an identified asset and whether the customer has the right to control the identified asset for a period in exchange for consideration. When determining whether an arrangement is or contains a lease, entities evaluate, among other things, whether the customer has the right to control the use of the identified asset. Once an arrangement is determined to be a lease or a contract containing a lease, you will need to determine the commencement date, lease term, lease payments and the discount rate, as you will need this information to determine lease classification and calculate the amounts initially recognized on the balance sheet.

Lease Classification: Lease classification is important because the pattern of expense recognition is different for finance vs. operating leases. The lessee will follow the same process for classifying the lease as under the existing standard ASC-840. While the criteria to determine whether a lease is a finance lease are similar to those for capital leases under ASC 840, there are two changes lessees need to be aware of:

1. The addition of a fifth criterion related to the specialized nature of the underlying asset; and

2. The removal of ASC 840’s bright lines and the introduction of judgment when determining whether a lease meets the economic life (the 75 percent test under ASC 840) or fair value (the 90 percent test under ASC 840) criterion. The FASB stated that “one reasonable approach” would be to conclude that “ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset, and that 75 percent of remaining useful life is still an acceptable benchmark.”

Initial Recognition & Measurement: Lessees initially recognize a lease liability for the obligation to make lease payments and a right-of-use (ROU) asset for the right to use the underlying asset for the lease term. The lease liability is measured at the present value of the lease payments over the lease term. The ROU asset is measured at the lease liability amount, adjusted for lease prepayments, lease incentives received and the lessee’s initial direct costs (e.g., commissions). ASC 842 provides several practical expedients and policy elections to make it easier to apply the new guidance. Listed in Figure 1 are various policy elections available to entities on adoption and related considerations. Refer link for published article in CalCPA . Link: California CPA - October 2021 (calcpa.org)

Subsequent Measurement: For operating leases, lessees measure the lease liability at the present value of the remaining lease payments, which results in the same subsequent measurement as the liability for a finance lease. They subsequently measure the ROU asset at the amount of the remeasured lease liability, adjusted for cumulative prepaid or accrued rent if the lease payments are uneven throughout the lease term, unamortized lease incentives, unamortized initial direct costs and any impairment of the ROU asset.?

Lessees recognize lease expense for these leases on a straight-line basis, which is similar to what is done under ASC 840. ROU assets for both lease types are subject to impairment testing under ASC 360, Property, Plant, and Equipment. For finance leases, lessees increase the lease liability to reflect interest and reduce the liability for lease payments made. The related ROU asset is amortized on a straight-line basis unless another systematic basis is more representative of the pattern in which the lessee expects to consume the asset’s future economic benefits.

Effects on Balance Sheet & Income Statement: Under ASC 842, the entity recognizes all leases, including operating leases, on the balance sheet. Both financing leases and operating leases create an ROU asset and a lease liability, initially measured at the present value of the future lease payments, to be reflected on the balance sheet.

For operating leases, the entity recognizes a single total lease expense and a gross up on the balance sheet related to the ROU asset and lease liability.

For financing leases, the entity recognizes amortization expense of the ROU asset separately from interest expense on the lease liability.

Disclosures: ASC 842 expands the disclosure requirements for both lessees and lessors. ASC 842-20-50-1 (lessee disclosure) states, “The objective of these expanded disclosures is to enable financial statement users to assess the amount, timing and uncertainty of cash flows arising from leases.” ASC 842 requires both lessees and lessors to disclose quantitative and qualitative information about their leases, the significant judgments and assumptions made in applying ASC 842 and the amounts recognized in the financial statements related to those leases.

Link for published article-https://a-us.storyblok.com/f/1015104/x/3c226b4619/1021-california-cpa.pdf