ASC 842 is a new accounting standard codification issued by the Federal Accounting Standards Board (FASB) that prescribes how public and private companies need to disclose leases in financial reporting. Technically, it’s an amendment to existing lease accounting standards, and it replaces ASC 840.
In the past, leases—particularly operating leases—have represented a major gap as investors and analysts try to understand an organization’s financial strength. Every lease a business or nonprofit takes on represents a financial asset and a financial risk, but Generally Accepted Accounting Principles (GAAP) treated capital and operating leases differently, and didn’t require operating leases to appear on balance sheets. Leases don’t represent the same level of risk as assets you own, but they represent a key piece of your financial portfolio, and reporting them provides a crucial layer of transparency.
This hole in accounting standards had the potential to turn an organization’s financial reports into an iceberg, where much of their portfolio was hidden beneath the surface, and analysts couldn’t gauge a company’s true level of risk. In fact, it’s estimated that including operating leases will collectively add about three trillion dollars in liabilities to corporate balance sheets.
ASC 842 requires all operating leases that last longer than 12 months to appear on balance sheets. This is the most significant change to accounting standards in years, and it has a much greater impact on lessees than lessors.
For businesses and nonprofits, ASC 842 has added complexity to the already cumbersome process of identifying, classifying, and reporting leases.
In this article, we’ll lay out what ASC 842 means for your organization and how to simplify the entire accounting process.
ASC 842 has been in the works for nearly a decade, and originally, the amendment was going to go into effect for all organizations for fiscal years starting after December 15, 2019. (Public business entities and nonprofits were required to implement the changes for fiscal years after December 15, 2018.) Because of the challenges public companies had ensuring compliance with the new standard, the deadline for private companies was extended for a year. And then COVID-19 devastated revenue for many businesses and significantly disrupted leases. Some payments were deferred or forgiven. Some leases were modified. And business-as-usual was put on hold.
In light of all of this, FASB decided to postpone the effective date for ASC 842 yet again by one year—but only for private organizations that haven’t already begun applying the changes.
Private companies that haven’t already released financial statements adopting ASC 842 can begin doing so for fiscal years beginning after December 15, 2021.
ASC 842 uses a broader definition of leases than US GAAP, forcing organizations to review their contracts for “embedded leases” which may not be identified as leases in the contract. In the past, accountants may not have even reviewed these contracts or had an opportunity to consider their impact on the organization’s liabilities and operating expenses. Reporting applicable embedded leases helps add another layer of transparency to your financial portfolio.
Under this expanded definition, a contract is a lease or contains one if it gives an entity control over “an identified asset” for a period of time in exchange for consideration. ASC 842 determines this transfer of control based on whether the entity receiving access to the asset obtains all of the economic benefits of the asset or the right to direct the asset’s use.
Basically, if a contract explicitly identifies a piece of equipment, vehicle, etc., and either gives you the right to direct its use or states that you alone will receive the benefits from it —in exchange for some form of payment—the contract may be a lease or contain one.
Sometimes this payment is tied to a service associated with the asset, rather than the asset itself. For example, a contract may include your right to use a tractor and require you to pay the supplier for fuel and ongoing maintenance for the duration of the contract. Whether it’s called one or not, that’s a lease.
Every time a contract gets renewed or modified, both parties must review the contract to see if changes in circumstances or clauses have changed whether the contract contains a lease.
Identifying and classifying leases is a core component of lease accounting, and ASC 842 slightly changes how this works. It changes the name of one lease classification and in the name of transparency, requires lessees to treat the two main categories more similarly.
Prior to ASC 842, when a lease transferred ownership from the lessor to the lessee or the lessee got most of the use from the leased asset, this was classified as a “capital lease.” ASC 842 changed the name of this classification to “finance lease.”
Finance leases may explicitly define the transfer of ownership in the contract, but there are two other reasons a lease may fall under this category:
- The lease payments amount to 90 percent or more of the asset’s fair market value.
- The lease duration exceeds 75 percent or more of the asset’s remaining economic life.
A forklift has an average lifespan of 10,000 hours of operation, and typical usage of 2,000 hours per year. Over the course of a five-year lease, an organization would likely use 75 percent or more of the forklift’s economic life, making this a finance lease. However, a higher quality forklift could last for twice as many hours, and if your organization used this equipment less frequently, the yearly hours of use would fall as well, which could change the same lease to an operating lease.
Now suppose the forklift is worth $20,000, and your lease payments are for $400 per month. By year four of the lease, you’d have paid $19,200—96 percent of the forklift’s fair market value, making this a finance lease again. Add the fact that the fair market value of a piece of equipment depreciates as its remaining lifespan dwindles, and it doesn’t take long for a lease to be classified as a finance lease.
Operating leases work differently. They don’t transfer ownership from lessor to lessee, and the lessor bears the greatest level of risk for the entire duration of the lease. Before ASC 842, these leases were referred to as “off balance sheet financing,” as they didn’t have to be reported in an organization’s balance sheet. Now, the only way a lease doesn’t wind up on your balance sheet is if it lasts for 12 months or less. This is regardless of what percentage of the fair market value your lease payments amount to or the percentage of the asset’s economic life you use over the duration.
Where this gets most complicated is in the process of actually identifying leases. Before, ongoing costs related to an asset didn’t always amount to a lease you’d have to report on a balance sheet. But if you’re contractually obligated to pay ongoing costs associated with the use of an asset (such as maintenance costs) to the organization that gave you the asset, those expenses qualify as payments for the “right to use” the asset—which makes you a lessee and the other party the lessor. If the duration of the contract lasts longer than 12 months, you have to disclose it, regardless of if it’s an operating or finance lease.
How lease accounting software helps
The stakes for lease accounting are high. Failing to comply with FASB can result in financial restatements, increased audit costs, decreased investor confidence, and even job loss. And even with the best lease accountants, human errors and oversights are bound to happen.
As your lease portfolio grows and your business enters into more contracts, it becomes harder to wade through legal documents to identify and classify all your leases, perform calculations, and remain compliant with ASC 842.
Thankfully, there’s an established solution: lease accounting and administration software. Organizations around the world use software like Tango Lease to give them peace of mind about ASC 842 and free their accountants to focus on other opportunities.
Here’s how it works.
The larger your organization, the more difficult it is to identify embedded leases and recognize your liabilities. Tango Lease enables your organization to sift through thousands of contracts for clauses and language that could represent a lease. Instead of pouring over every document, your accounting department simply needs to review the ones that matter.
A modern, robust lease accounting software solution should be able to automate aspects of the compliance process and correctly perform complex FASB calculations for you. Tango Lease simplifies compliance by automatically generating accounting schedules and posting the required information in the General Ledger. This saves external accountants hours every month, and can reduce your lease accounting audit costs by up to 25%.
Every time a contract changes, it could affect whether or not it contains a lease, or how that lease needs to be classified in financial reports. It’s your responsibility to review lease modifications and ensure you’ve correctly accounted for every lease, but when your accounting team has thousands of separate leases to monitor, individual lease schedules and changes inevitably fall through the cracks.
Tango Lease automatically creates lease schedules for every lease in your portfolio. The Critical Dates feature automatically tracks and notifies you about key dates and action items, so no matter how many leases you manage, you’ll know when changes occur and if the nature of these modifications reflects a change in a contract’s status.
Tango Lease is a complete lease accounting, administration, and financial solution. Coupling artificial intelligence with machine learning, Tango Lease automatically retrieves and organizes the information your administrators need and conducts lease accounting calculations. Our software makes compliance with ASC 842, IFRS 16, and GASB 87 a breeze.
With Tango Lease, your lease professionals can save hours on tedious processes and reclaim that time for the problems and opportunities that truly require their expertise.
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