Simplifying ASC 842: A Guide to Lease Accounting

Let’s break down the fundamental concepts that underpin ASC 842:

• Lease vs. Service Contract: Not every agreement where you obtain access to an asset is a lease. Particularly, ASC 842’s definition of a lease is of a contract that transfers control of the specified asset for a defined period in exchange for consideration (payment). On the other hand, service contracts focus on providing services rather than transferring control.

Here’s a simple trick to remember:

• Lease: You control the asset and tell it what to do (think “Lease and Control“).
• Service Contract: You receive a service, and the provider controls how it is delivered (think “Service and Provider“).
• Lease Classification:  ASC 842 classifies leases into two categories for lessees: finance leases and operating leases. This classification determines the accounting treatment for the lease. Finance leases are essentially treated like a loan to purchase the asset, with a right-of-use asset and a lease liability recognized on the lessee’s balance sheet. Operating leases are recorded differently, with only the lease payments expensed over the lease term.

The classification hinges on several factors, including the transfer of relevant risks and rewards associated with ownership, the lease term relative to the asset’s economic life, and the purchase option (if any). We’ll delve deeper into lease classification in a future blog post.

• Key Lease Terms: Understanding the key terms of a lease agreement is crucial for accurate accounting under ASC 842. These terms include the lease commencement date, lease term, lease payments (including any variable payments), initial direct costs, discount rate, and the guaranteed residual value (if applicable).

A Deep Dive for Lessees

Now that we’ve covered the fundamentals let’s explore the specific accounting requirements for lessees under ASC 842.

• Lease Classification:  As mentioned earlier, the classification of a lease (finance or operating) determines the accounting treatment. Most leases will now be classified as finance leases, with a right-of-use asset and a lease liability reflected on the lessee’s balance sheet.
• Accounting by Lease Classification:
  • Finance Leases: For finance leases, lessees recognize a right-of-use asset representing their right to use the leased asset. They also recognize a lease liability equivalent to the present value that is of the minimum lease payments. The right-of-use asset is then depreciated over its useful life, and the lease liability is reduced with each lease payment.
  • Operating Leases: Under ASC 842, operating leases are more straightforward to account for. Lessees only recognize the lease payments as an expense over the lease term without impacting the balance sheet.
• Subsequent Measurement:  Once a lease is recognized, lessees need to account for it throughout the lease term. This involves recording depreciation on the right-of-use asset that represents the lessee’s right to use the leased property. Each lease payment reduces the lease liability, reflecting the lessee’s decreasing obligation under the lease agreement.
• Remeasurements:  Certain events can trigger a reassessment of the lease liability and right-of-use asset. These events might include changes in the estimated remaining lease term, the discount rate used to calculate the present value of lease payments, or unexpected fluctuations in residual value (if applicable). Remeasurement ensures the financial statements continue to reflect the most accurate representation of the lease obligation.
• Modifications:  Significant changes to a lease’s terms can be treated as a new lease under ASC 842. Examples include exchanging additional consideration (e.g., upfront payment for lower rent), extending the lease term, or altering the scope of the leased property (adding or removing space). Understanding these potential modifications is crucial, as they can significantly impact the financial statements. For instance, a lease extension would increase the right-of-use asset and lease liability. In contrast, adding leased space would require allocating the lease payments between the original and additional space.