ASC 842 Lease Accounting Definition, Tips for Adoption & Challenges
ASC 842 is the new lease accounting standard which became effective for public companies on January 1, 2019 and private companies on January 1, 2022.
Even if a company has already implemented ASC 842, they’re still required to evaluate new leases and ensure that the new standard is applied.
As experts in implementing ASC 842 lease accounting, evaluating new leases to ensure that the guidance is applied correctly and more, we’ve outlined some helpful tips for ensuring you’re in compliance and streamlining adoption into your company’s process.
Everything you need to know about ASC 842:
- What is ASC 842?
- What are the Lease Types Under ASC 842?
- 5 Recommended Tips for Adopting ASC 842 & Streamlining the ASC 842 Lease Accounting Process
What is ASC 842?
ASC 842 governs how entities record the financial impact of their lease agreements, with the vast majority of leases recorded on the balance sheet. This new standard was established to improve transparency into a company’s liabilities resulting from leasing arrangements and to reduce the number of off-balance sheet entries.
What are the Lease Types Under ASC 842?
Under ASC 842, a lease is a contract or portion of a contract which conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration.
There are two types of leases under 842: finance leases (formerly known as capital leases under ASC 840) and operating leases.
1. ASC 842 Finance Leases
In order to be classified as a finance lease, at least one of the following criteria must be true:
- Transfer of ownership of the asset to the lessee occurs at the end of the initial lease term.
- The lessee is reasonably certain that they will exercise a purchase option at the end of the lease term.
- The leased asset has no alternate use to the lessor at the end of the lease.
- The term of the lease is a major part of the economic life of the underlying asset. While major is not quantified, most organizations use 75% or more as the baseline measure.
- The present value of the lease payments is materially all of the fair value of the leased asset. While materially is not quantified, most organizations use 90% or more as the baseline measure.
2. ASC 842 Operating Leases
In order to be classified as an operating lease, none of the finance lease criteria exist. The main attribute of an operating lease is that there is no transfer of ownership at the end of the initial lease term.
5 Tips for Adopting ASC 842 & Streamlining the ASC 842 Lease Accounting Process
1. Understand ASC 842 and the implications of ASC 842 implementation
First and foremost, a company considering an ASC 842 lease accounting implementation needs to understand the guidelines and required changes both in general approach and actual implementation.
For best results, it can be most beneficial to turn to an ASC 842 implementation consultant or team for guidance in identifying exactly how and where your business may be subject to change.
2. Review current leases to assess and determine ASC 842 lease accounting applicability
All contracts across the organization have to be reevaluated to determine if elements of the agreement fall under ASC 842.
One element that is frequently missing is an embedded lease, which occurs within a contract even though the word or concept “lease” may not appear.
Doing a manual review of all the contracts in an organization can be daunting, which is why software is sometimes introduced to manage the implementation and maintenance of ASC 842 lease accounting guidelines.
3. Determine what rate to apply to your leases under ASC 842
A critical part of applying ASC 842 lease accounting standards is to determine what rate to apply when you calculate the present value of lease payments to properly capture the lease liability.
The recommendation is to use the incremental borrowing rate in the lease. In the event that a lease does not include an incremental borrowing rate, private companies have the option to utilize the risk free rate for the lease.
Some drawbacks of using the risk-free rate include but are not limited to the following:
- The lessee is locked into using the risk-free rate on future leases.
- The assets and liability recorded on the balance sheet will be higher since the risk-free rate will be lower than an incremental borrowing rate in the lease. This will change a company’s net working capital calculations and potentially impact compliance with any established thresholds associated with investors and/or with their bank.
- Classification of a lease can be changed to a finance lease if the present value of the lease payments is equal to or greater than the fair value of the asset.
4. Create ASC 842 lease accounting policy memos
Creating policies and procedures need to be considered when transitioning to new accounting guidelines such as ASC 842.
A policy memo will demonstrate to a company’s auditor that the processes put into place are in alignment with the guidelines and that they are being performed in a timely manner.
The recommendation is to be thorough and transparent when documenting the process to transition to ASC 842 as well as to provide detail for established policies and processes, helping to make your audit as smooth as possible.
5. Ensure your people and systems are ready for ASC 842 adoption
Communicating across your organization and developing proper documentation methods will ensure everyone is on the same page with regard to adopting the change in processes and policies associated with ASC 842.
Leveraging software to support an ASC 842 implementation and ongoing maintenance has the following advantages:
- Automation. Instead of manually examining every lease, lease accounting software products use artificial intelligence to extract all the key information from your contracts which can save your team days and potentially weeks of work.
- Compliance. Lease accounting software incorporate ASC 842 guidelines and provide real time updates to the guidance, which minimize the risk of being out of compliance.
- Standardization. This ensures evaluation of leases is consistent.
- Single Source of Truth. All lease information is centralized and accessible by the internal accounting team, stakeholders and auditors.
Final Thoughts on How to Overcome Challenges Related to ASC 842 Lease Accounting
ASC 842 lease accounting brings many challenges for public and private companies alike, which is why preparation is key to ensure a seamless and successful transition.
If you’re experiencing pain points regarding implementing the ASC 842 lease accounting process or ensuring its being applied correctly to new leases, it can be beneficial to turn to an ASC 842 resource for guidance.
Need ASC 842 Implementation Support?
Bridgepoint has helped numerous public and private companies through their ASC 842 transitions. We also have deep experience working with software companies on a wide range of technical, operations and finance initiatives.
Contact our expert team to manage the entire transition on your behalf — or handle discrete tasks like contract review, systems analysis or configuration assessments.