Leasing assets is popular among businesses due to its benefits in terms of purchasing power, lower maintenance costs, and better cash flow management. The lease accounting standards were pretty simple for businesses, but many investors believed they didn’t provide the true picture of the business’s financial position. The Financial Accounting Standard Board (FASB) announced major changes to the lease accounting standards. The new standards for leases are given under US GAAP ASC 842.
Most accounting standards remain the same for lessors, while most of the changes occur in the accounting for lessees. Lessees are now required to record the lease arrangements (both capital/finance and operating leases) in the balance sheet. According to FASB, these changes provide transparency regarding the accurate financial position of the businesses for the investors. However, it also complicates things for businesses. If you are a business owner, here’s what you need to learn about the new lease accounting rules.
Transition to the New Accounting Standard ASC 842
Previously, under the old accounting standards ASC 840, the lessee used to classify leases under finance (capital) and operating leases. The finance or capital leases were required to be recorded as lease assets or liability in the balances sheet, while operating leases were recorded in the footnotes. Under the new lease accounting standards ASC842, the lessee must record both finance and operating leases on the balance sheet. FASB has made it compulsory for public companies to transition to new standards by 2019, while private companies have been given time till December 2022. The private companies need to check the ASC 842 effective dates to transition to new standards within time.
ASC 840 vs. ASC 842
Apart from the major impact on the balance sheet, some other changes have also been implemented under ASC 842. These include the following:
Time of Lease Classification
Under the old lease standard (ASC 840), leases were classified as either capital or operating at the time of lease inception. Under the new lease standard (ASC 842), leases are classified as either capital or operating lease time of lease commencement.
Under the new lease accounting standards, companies have to record the lease payments on the balance sheet for both capital and operating leases based on the present value of their future payments. However, the expense recognition will differ for both capital and operating leases.
For operating leases, expense recognition is pretty simple. The lessee has to recognize lease expenses over the lease term on a straight line basis. However, for finance leases, the lessee must record both the amortization and interest expenses.
Lease Classification Criteria
Under ASC 840, leases were classified as either finance or operating based on the following four criteria:
- Whether the ownership of the leased asset is transferred at the end of the lease term
- Option for the lessee to purchase the leased asset
- The lease term is greater than or equal to 75% of the useful life of the leased asset
- The present value of the lease payments is greater than or equal to 90% of the fair value of the leased asset
If the above criteria were fulfilled, the lease was classified as a finance lease. If any of the above criteria were not fulfilled, the lease was classified as an operating lease.
Although the basic four requirements for lease classification remained the same under ASC 842, it removes the bright lines related to 75% and 90% of points 3 and 4. In addition, other criteria related to specialized assets were added to the lease classification criteria under new rules. The fifth criterion is:
- The leased asset is so specialized that the lessor has no alternate use for the leased asset at the end of the leased term.
Under new accounting standards for leases, a lease is only recorded on the balance sheet if the lease term is more than 12 months. If the leased term is less than 12 months, the lessee doesn’t have to recognize the agreement as a leased asset and a lease liability on the balance sheet.
Residual Value Guarantees
Under ASC 842, the treatment for residual value guarantees has slightly changed. The entire residual value was added to the lease payments under the old leasing accounting rules. However, under the new accounting rules, only the amounts expected to be owed at the end of the lease term are added as lease payments.
Leasing provides certain benefits to businesses regarding purchasing power and easy cash flow management. Because of these benefits, many businesses prefer to lease equipment and assets instead of purchasing them. However, some major changes in the lease accounting rules have made it challenging for businesses to record leases. Transitioning to the new standards is difficult; however, all companies must comply with new standards before the effective dates provided by FASB.
Hopefully, after reading this article, you might have learned the key differences between the old lease accounting standard (ASC 840) and the new lease accounting standard (ASC 842). Learning the differences between ASC 840 and ASC 842 helps to understand the changes that have been made and how it helps businesses to become more financially transparent.