The new lease accounting standards, ASC 842 and IFRS 16, have redefined how entities report lease transactions, creating a significant impact on the balance sheets of lessees and lessors.
ASC 842, known as the Accounting Standards Codification Topic 842, and IFRS 16 are the updated lease accounting standards that have been issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), respectively. Their main objective is to increase transparency in lease accounting by recognizing lease assets and lease liabilities on the balance sheet.
The impact of ASC 842 and IFRS 16 is profound, particularly on lessees. Both standards require lessees to recognize:
Lessors continue to classify leases as operating or finance leases. However, they must align with the enhanced disclosure requirements to provide more information about their leasing activities.
ASC 842 and IFRS 16 define a lease as a contract or part of a contract that conveys the right to control the use of an identified asset for a period in exchange for consideration. The scope affects a wide range of industries and includes most contracts that involve the use of a specific asset.
Entities are required to assess and identify agreements that meet the definition of a lease under these new standards and apply the accounting model accordingly.
When a company enters into a lease agreement under the new accounting standards, ASC 842 and IFRS 16, it must recognize a right-of-use asset and corresponding lease liability on the balance sheet. Initial recognition and measurement must be carefully assessed to comply with these standards and reflect the lease’s financial impact accurately.
A contract is identified as a lease if it conveys the right to control the use of an identified asset for a period in exchange for consideration. Control is present when the lessee has both the right to obtain substantially all the economic benefits from the use of the identified asset and the right to direct the use of that asset.
Under IFRS 16, all leases are treated similarly to finance leases, with lessees recording a right-of-use asset and a lease liability for virtually all leases. ASC 842 retains the dual-model approach, classifying leases as either finance or operating. However, both require similar recognition of a right-of-use asset and a liability.
The lease components of a contract should be separated from the non-lease components. A lessee should allocate the consideration in the contract to the lease and non-lease components, based on their relative standalone prices. However, for practicality, a lessee may elect to account for each separate lease component together with the associated non-lease components as a single lease component.
The lease term includes any options to extend or terminate the lease if it is reasonably certain that the lessee will exercise that option. This assessment requires judgment and should reflect all relevant facts and circumstances.
Under the new lease accounting standards ASC 842 and IFRS 16, lessees must recognize lease assets and lease liabilities on their balance sheets, and the nature of these leases affects the income statement and statement of cash flows in distinct ways.
Under both ASC 842 and IFRS 16, lessees are required to recognize a Right-of-Use (ROU) asset and a corresponding lease liability for almost all leases. This includes operating leases which, under previous guidance, were not recorded on the balance sheet. The ROU asset is initially measured at the present value of the lease payments, and the lease liability reflects the obligation to make these payments.
The treatment on the income statement differs between operating and finance leases.
ASC 842 and IFRS 16 have specific requirements for the statement of cash flows.
This segregation provides a clearer picture of an entity’s financial obligations and operating costs arising from leasing activities. The impact on the financial statements is significant and requires careful consideration to ensure compliance with the financial reporting standards.
Under ASC 842 and IFRS 16, the subsequent measurement and reassessment of operating leases require meticulous attention to changes in lease terms and asset conditions. This process ensures that the lease liability and right-of-use (ROU) assets are accurately reflected in the financial statements over the lease term.
When there are lease modifications not accounted for as separate contracts, lessees must reassess the lease classification and update the lease liability and corresponding ROU asset. Reassessments are triggered when there is a change in the lease term, indicating that the lessee is reasonably certain to exercise an option to extend or terminate the lease, or when there is a modification in expected lease payments. Lessees must use a revised discount rate to remeasure the lease liability for the new lease term or modified payments.
Subsequent to initial recognition, the ROU asset is generally depreciated on a straight-line basis over the lease term, while the lease liability is measured at the present value of remaining lease payments using the discount rate established at the commencement date. Lease payments may include fixed payments, variable lease payments dependent on an index or rate, and amounts expected to be paid under residual value guarantees, minus any lease incentives received.
ROU assets should be reviewed for impairment when there is an indicator of impairment, similar to other non-financial assets. If an ROU asset is considered impaired, the carrying amount of the ROU asset is reduced to its recoverable amount, and an impairment loss is recognized in the income statement. The subsequent measurement of the impaired ROU asset depends on whether the impairment was reversible and complies with the relevant impairment guidance for assets under ASC 842 and IFRS 16.
Under ASC 842 and IFRS 16, both lessees and lessors face enhanced disclosure and reporting requirements, ensuring greater transparency in financial statements. These standards necessitate that entities provide detailed information regarding the nature of their leasing activities.
Lessees must meticulously disaggregate the total lease cost, separating it into lease components such as fixed lease costs, variable lease costs, and short-term lease costs that do not reflect a finance lease. They should also state amounts associated with sublease income. Compliance with the new standards requires lessees to provide journal entries that reflect both the recognition and measurement of leases on the balance sheet and disclose these in their financial statements.
In practical terms, lessees must disclose qualitative and quantitative elements, including:
Public and private companies are obliged to comply with these requirements, with the objective to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows from leases.
Lessors, on their part, should include in their financial statements information about the carrying amount of the leased assets, separated between those subject to operating leases and finance leases. They should also present the related income on the income statement.
Lessors must disclose:
The disclosure aims to provide a detailed perspective on the lessor’s leasing activities, assisting in assessing the risks associated with the lease portfolio and the financial impact of the leases on the lessor’s financial position, performance, and cash flows.
Adopting the new lease accounting standards, ASC 842 and IFRS 16, mandates a shift in reporting for operating leases. Entities must navigate through a series of practical expedients and a modified retrospective transition approach aimed at streamlining compliance.
Under ASC 842, lessees and lessors can leverage practical expedients to ease the transition. These expedients, which aim to reduce complexity, are options that entities can elect to apply and include:
These expedients must be applied consistently to all leases and are particularly beneficial for private entities, which often have limited resources for transition.
Entities transitioning to ASC 842 are required to apply a modified retrospective transition approach. This includes:
For public companies, this transition guidance was effective for fiscal years beginning after December 15, 2018. Private companies and private not-for-profit entities had an extended implementation deadline for fiscal years beginning after December 15, 2020.
Entities must provide the transition disclosures required by ASC 250, Accounting Changes and Error Corrections, which includes the nature of and reason for the change in accounting principle, method of applying the change, and description of the prior-period information that has been retrospectively adjusted.
The adoption of new lease accounting standards under ASC 842 serves as an intricate roadmap for accounting compliance that affects a broad spectrum of leases, ranging from finance leases to operating leases. It requires meticulous planning and a strategic approach for a successful transition.
The transition to the ASC 842 standard for operating lease reporting brings about significant operational changes, demanding meticulous planning and precise execution to achieve compliance.
Implementing the new lease accounting standard, ASC 842, presents several challenges for organizations. They must reassess their lease agreements and adjust their accounting practices to recognize lease liabilities and Right-of-Use (ROU) assets for all leases, including operating leases, on the balance sheet. This is a substantial shift considering that under previous guidelines, operating leases were not reflected on the balance sheet. The initial application period and subsequent reporting periods will require careful analysis and recording of lease terms and payments, with entities needing to maintain control and ensure transparency throughout the process.
To comply with ASC 842, entities need to adjust their financial reporting processes and systems. Lease accounting now necessitates a more detailed level of tracking and reporting, requiring entities to capture data points that weren’t previously necessary. Companies must:
This change in accounting for lease liability and lease payments requires that both accounting and IT departments work closely to maintain the integrity of financial reporting.
Lease accounting software is integral to implementing ASC 842 standards effectively. When choosing a software solution, consider:
A robust software solution should offer functionalities to streamline and automate lease classification, measurement, and overall lease management. The right software will facilitate compliance, reduce the risk of errors, and potentially save time and costs during the transition to ASC 842 and beyond.
ASC 842 and IFRS 16 have brought significant changes to lease reporting, impacting various sectors. Each industry faces unique challenges in accounting for leases, given the nature of assets involved and the operations of the business.
Real Estate: Leases for buildings and land typically encompass longer lease terms, which necessitate careful consideration of lease modifications and renewals — affecting the reported lease asset and liability. Real estate companies dealing with significant property leases need to ascertain the present value of future lease payments, directly affecting their balance sheets.
Equipment: Sectors utilizing expensive equipment, like manufacturing or construction, need to distinguish between leases that are in substance finance leases and those that are operating leases. The distinction affects the recognition of leased assets and liabilities. A finance lease would necessitate recognizing an asset and obligation, reflecting ownership rights and commitments. For operating leases, a right-of-use asset and corresponding liability are recognized, factoring in the present value of future lease payments.
Entities in the oil, gas, and mining sector often lease large, specialized equipment for exploration and production. The assessment of the lease term is crucial as it determines the asset valuation and lease liability. Regarding mineral rights, these businesses must consider whether a lease on minerals, oil, or gas includes intangible assets or if it is purely a tangible asset lease. Moreover, lessor accounting procedures must accurately reflect income from leasing out owned assets used in operations.
In agriculture and forestry, leases for land and biological assets, such as crops and timber, are prevalent. These entities must evaluate the lease terms to establish if they encompass the entire agricultural cycle or the expected life of plants and timber. The value of these biological assets, their predictability, and potential returns influence lease accounting. Also, the definition of a lease needs to be carefully analyzed to determine if contracts for the use of land or forests for agricultural purposes meet the criteria of a lease under ASC 842 and IFRS 16.
The new lease accounting standards significantly change how entities record and disclose operating leases. Here, common questions about these changes are addressed to assist with understanding the impact of ASC 842 and IFRS 16.
ASC 842 requires lessees to recognize nearly all leases on the balance sheet, while IFRS 16 eliminates the classification of leases as either operating or finance for lessees. Under IFRS 16, a lease is always treated in a similar way to finance leases under ASC 842, where a right-of-use asset and a lease liability are recognized.
Under ASC 842, a lessee should recognize an asset representing its right to use the leased asset and a liability for its lease obligations. This includes recording the present value of lease payments as a lease liability and a corresponding right-of-use (ROU) asset, adjusted for prepaid or accrued lease payments.
The ASC 842 standard took effect for public companies for fiscal years beginning after December 15, 2018, and for private companies for fiscal years beginning after December 15, 2021. Early adoption was permitted.
Under ASC 842, lessors classify leases as finance, operating, or sales-type. For operating leases, the lessor continues to recognize the asset, and lease income is recognized based on the lease term. Lease receivables and depreciable asset rights are recognized for finance leases.
Lessees must disclose qualitative and quantitative information about their leasing activities, including the nature of leases, significant judgments, and making and carrying amount of ROU assets and lease liabilities. A maturity analysis of lease liabilities also needs to be provided.
Lessee’s journal entries for operating leases under ASC 842 involve debiting the ROU asset and crediting the lease liability at lease commencement for present value of lease payments. Lease expenses are recognized based on the straight-line method, splitting between reduction of the lease liability and recognition of lease expense.