Accounting Standards Codification (ASC) 842 – Leases came as a response to the mistreatment of items on the balance sheet. At the beginning of the twenty-first century, multiple very large public companies were pursued by the government for fraudulent financial reporting. As a result, the US government introduced the Sarbanes-Oxley act in 2002 to promote transparency. This bill was later joined by ASC 840 published in 2010 and later ASC 842 in 2016, also known as Accounting Standards Update (ASU) 2016-02—Leases. These standards outline the proper accounting treatment for leased assets. This article will outline the relevance of ASC 842, review the comparative roles of both ASC 842 and ASC 606—Revenue, and consider the different interactions that can occur between the two.
The Financial Accounting Standards Board (FASB) updated ASC 840—Leases, based on ASU 2016-02 to clarify the accounting for and classification of the types of leases. Under ASC 840, leases would be classified as operating and would not appear in the financial statements beyond a mention in the footnotes. This allowed for a lot of subversive flexibility, and the new standard was meant to combat that. Nearly all leases show up on the financial statements, allowing for a more accurate representation of what future payment obligations a company possesses.
Other differences include assessing costs embedded in the contract, standards classifying leases, determining a Company’s borrowing rate, and recognizing leases using fair value principles. These will be further discussed in the section below.
The Roles of ASC 606 and ASC 842 in Contracts
First, it may be helpful to review the five steps of ASC 606: Revenue Recognition. To learn more about these steps than we have time for here, read The Five-Step Method.
5-Step Revenue Process
When identifying the contract and performance obligations, it is important to analyze the different components of a lease. ASC 842-10-25-2 specifies various circumstances under which an item may be classified as a finance lease:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments, in accordance with paragraph 842-10-30-5(f), equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
These requirements assist companies in determining how a lease should be reported. Once the classification has been determined, companies can begin to analyze the performance obligations that exist. These obligations could include insurance, taxes, or maintenance. When these are determined, the company can recognize the lease under ASC 842 and the non-lease components under ASC 606—Revenue. We will discuss the practical expedient involved in a later section.
Combination of Lease and Non-Lease Components
Once the underlying asset has been recognized as a lease, the components must be separated out unless the company elects to take the practical expedient. Lease components must meet both criteria from ASC 842-10-15-28 to be recognized:
- The lessee can benefit from the right of use either on its own, or together with other resources that are readily available to the lessee.
- The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract.
When the standard describes “right of use,” it means the lease asset being used by the company. Often the company has tools at its disposal which augment the use of the asset. These would not be included in the lease since they did not come as part of the contract. Some examples of things that could be in the contract, but be counted as non-lease components, are insurance related to the item, maintenance offered by the selling company, and warranties.
Practical Expedient Over Lease Component Combination
An option that ASC 842 permits is to recognize the lease and non-lease components as a singular asset or liability. This practical expedient simplifies the process since it relieves the company from performing a price allocation, but it will leave the lease to be a larger single item on the balance sheet. This also requires public companies to disclose what kind of assets were not separated out. A group from Deloitte found that it was fairly common for companies to make this election, but the practical expedient was applied to specific leases in the company, and not for all leased assets.5
Repurchase and Renewal Agreements
Under ASC 840, many companies benefited from leaseback transactions. This occurs when a company sells an asset and then leases it from the buyer. For example, assume Syndis Co. (seller-lessee) sells an office building to Hulders Co. (buyer-lessor) for $5 million. The asset no longer appears on Syndis Co.’s balance sheet. Syndis Co. then leases back the building from Hulders Co. as an operating lease, allowing it to keep the building off its books while still using the asset.6 With the ASC 842 update, the lease remains on Syndis Co.’s balance sheet, but there are still some advantages to the transaction.
The difficulty inherent in leaseback transactions lies in the recognition of the repurchase agreement. When these transactions take place, there is a clause that allows the seller-lessee to buy back the asset after a set amount of time, sometimes at a set price. This repurchase agreement comes under scrutiny when determining if the sale of the building to the buyer-lessor party is considered a sale or a failed sale. In the case of a failed sale, or if the terms of the arrangement would be similar if the company had not sold the building in the first place, the lease would count as a financing agreement instead of a sale. To learn more about this topic, see our article, Repurchase Agreements.
Implications for Businesses Implementing ASC 842
As companies have adopted the ASC 842 standard, there has been a significant impact on public companies’ financial reporting.
As operating leases have been added to the balance statement, assets for lessors and lessees have increased. Lessees’ liabilities have also increased. When comparing to commonly held measures, financial statement issuers and the financial statement users should recognize the impact the new standard has on comparative ratios. For example, a company that has been consistently profitable may rapidly lower or increase its debt to equity, when for the company, virtually nothing has changed. This is a prime example of an economic change, not a physical one.
We will now record our operating leases, related to datacenters, offices, research and development facilities, retail stores, and various equipment, under the operating lease right-of-use assets, other current liabilities, and operating lease liabilities lines in the balance sheet. This results in a net increase in assets and liabilities of $6.6 billion as of June 30, 2017 and a net increase in assets and liabilities of $5.2 billion as of June 30, 2016. As, I previously stated, this change will have no impact on our income statement or cash flows.
For uniformity, Microsoft elected to publish the comparative financials for the previous two years as if the standard had been in place for that time. In the end, the operating leases added 5% to Microsoft’s long-term assets and about 2% to its total assets. This can seem negligible, but when considering the high dollar impact on Microsoft’s balance sheet and the sensitivity of certain financial ratios, it is important to be aware of these changes.
ASC 842 has pushed companies to report more transparent financial information by requiring operating leases to be shown on the balance sheet. As companies continue to adopt this standard, it is important to recognize some of the intricacies in accounting for this standard as well as the effect it can have on the company. Recognizing the components of a lease, being aware of the several practical expedients available under the standard, and understanding the other lease purchasing options will allow a company to accurately account for leases. As this lease standard is applied, it will allow shareholders to be more informed and business management to make better informed decisions.
- ASU 2016-02: “Leases (Topic 842).”
- KPMG, “ASC 842 and IFRS 16 Top Differences.” January 2021.
- Shemaria, Justin. Lease Query. “ASC 840 vs ASC 842: Differences between the Old and New Lease Accounting Standard.” February 2020.
- EY, The Private Angle: “Navigating the accounting requirements of the new leases standard.” August 2020.
- Deloitte, Heads Up: “Reasonably certain of your lease disclosures? Observations on first-quarter filings.” July 2019.
- Rashty, Josef. The CPA Journal. “An Analysis of the New Sale and Leaseback Guidance.” September 2018.
- ASC 842 and IFRS 16 Top Differences
- Leases (Topic 842)
- ASC 840 vs ASC 842: Differences between the Old and New Lease Accounting Standard
- Navigating the accounting requirements of the new leases standard
- Reasonably certain of your lease disclosures? Observations on first-quarter filings
- An Analysis of the New Sale and Leaseback Guidance