A Guide to ASC 842 Lease Accounting

January 9, 2023

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As finance and accounting departments manage challenges such as limited resources and an increased volume of data, they also must navigate a new lease accounting standard called the Accounting Standard Codification 842 (ASC 842), which updates the definition of a lease and requires businesses to report operating leases on their financial statements.

The Financial Accounting Standards Board (FASB) created the standard in 2016, with the goal of correcting the perceived problem of lessees leaving operating leases off their balance sheets. Analysts and investors argued that companies with operating lease payments each month appeared less indebted than companies with mortgages for office space or other kinds of financing arrangements to report on their balance sheets.

Notably, the FASB announced public companies had to comply with the standard for fiscal years after December 15, 2021. After receiving an extension, private companies must comply with ASC 842 by their first annual report of 2022 – which, for most calendar-year companies, was December 31, 2022.

The need for private companies to comply with ASC 842 requirements continues to be daunting for some. However, private companies moving toward compliance or refining their reporting processes for the future can keep track of their leases with updated lease accounting software that is tailored to comply with the ASC 842 standard.

How is ASC 842 compliance challenging, and how can companies adapt?

Prior to ASC 842, lessees could leave certain leases off their balance sheets if they passed the “bright line” test. This test required specific lease term lengths and minimum lease payments based on the asset’s economic life and fair value in order for the lease on that asset to be included on a balance sheet. Now, accountants must track down all leases that previously went unreported due to the bright line test.

The first step to complying with ASC 842 is to pin down and include agreements that now count as leases under the new standard. With the exception of certain short-term leases, both “operating leases” and “finance leases” must be reported. The new lease accounting standard defines a lease as an operating lease when the lessee does not control the underlying asset and as a finance lease when a lessee does control the underlying asset.

The new rule also introduces several new terms that accounting departments must adopt when tackling their lease accounting, such as “right-of-use (ROU) asset” and a “lease liability.” ROU assets are those that will be capitalized by the lessee and represent the lessee’s right to use an underlying asset for the lease term. Rather than label the asset as a capital asset – such as a truck – the ROU description will enable financial statement users to separate those assets actually owned from those capitalized because of leases.

Although the new standard includes some changes that affect lessor accounting and disclosure, such as eliminating leveraged leases, the new rule mostly affects lessees.

How does ASC 842 affect leveraged lease arrangements?

Lessors previously enjoyed reporting benefits with leveraged lease accounting under the old standard. The old way resulted in a greater portion of the income reported early in the lease, and in cases of a tax-leveraged lease, the yield on the lease investment was generally higher. But the new lease accounting standard eliminates “leveraged lease” as a lease classification. This is true for any lease with a commencement date on or after December 15, 2021 – the effective date of ASC 842 for public companies. The new standard stipulates that leveraged leases with a commencement date prior to December 15 will be grandfathered for lessors.

Determining the commencement date for leverage lease agreements is tricky. Often leveraged leases are large transactions structured and arranged well before an asset is available to be leased. For instance, assets with values in excess of $75 million are often financed via a leveraged lease, and often the assets are constructed or manufactured years before the commencement of the lease. It is unknown how ASC 842 will be applied to these transactions if the projects are not yet complete.

Any modification of a leveraged lease on or after the effective date will require application of the new lease accounting standard. In addition, if a lessee exercises an option to extend a lease and exercise of that option was not previously reasonably assured, it is considered a modification for purposes of this rule.

How can ASC 842 lease accounting software help companies meet standards?

Compliance with ASC 842 will continue to be a necessity. To meet the challenge of complying with ASC 842 standards, accounting departments should purchase lease accounting software created after ASC 842 standards were first published in 2016. That’s because software solutions that account for the nuances of the new lease accounting standard are ideal.

Bloomberg Tax Fixed Assets software helps users differentiate between operating and finance leases. It also tracks leased assets by entity and enables grouping and flexible reporting of ROU assets and lease liability, amortization, and interest expense.

To better comply with ASC 842, software also must enable accountants to centralize all leases in a single database, automate accounting calculations, and generate key reports so leases can be properly disclosed on financial statements. Bloomberg Tax’s software accounts for the nuances of ASC 842 reporting and is nested within a larger suite of fixed asset accounting tools – Bloomberg Tax Fixed Assets – allowing tax departments to streamline their reporting to one system and eliminate inefficiencies.

In addition, it is important for companies that report both within and outside of the U.S. to have lease accounting software that is compatible with ASC 842 and International Financial Reporting Standards (IFRS) 16 – a rule that governs lease accounting standards outside of the United States. Our software allows accountants to apply whichever standard they follow to their reporting.

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