The benefits of an ASC 842

ASC 842 Leases fundamentally changed lease accounting for lessees. The development of the new guidance originally started as a joint project of the FASB and IASB in 2006 to develop consistent requirements for lease accounting under US GAAP and IFRS. Operating leases are now required to be recognized on-balance, resulting in the recognition of a right-of-use asset and a lease liability regardless of lease classification.

In this blog post, we give an overview of the major changes in lease accounting under ASC 842.

ASC 842 – Summary of changes: The 5 key differences

Lessee accounting – Initial measurement

The lease liability is initially measured at the present value of the future lease payments. When determining the discount rate for the lease for calculation of the present value of the lease payments, the lessee should generally use the rate implicit in the lease. The right-of-use asset is initially recognized at the amount of the lease liability.

Initial direct costs and prepaid lease expenses increase the carrying amount of the right-of-use asset, while incentive payments already received from the lessor reduce the carrying amount. There is no difference between operating and finance leases regarding initial measurement.

Lessee accounting – Subsequent measurement

Subsequent measurement for the lease liability is identical for operating and finance leases and based on the effective interest method. The carrying amount of the lease liability is increased by interest calculated using the discount rate and reduced by lease payments made during the period.

The lessee is required to remeasure the lease liability using a revised discount rate if there is a change in the lease term, a change in the assessment of a purchase option, or a change of the amount expected to be paid under a residual value guarantee. ASC 842 requires remeasurements of the lease liability to be recognized as an adjustment to the right-of-use asset.

For finance leases, lessees are required to recognize amortization of the right-of-use asset separately from interest on the lease liability in the income statement. The right-of-use asset is generally amortized on a straight-line basis over the lease term. If the lease liability is remeasured, the amortization of the right-of-use asset has to be adjusted on the date of remeasurement.

For operating leases, the right-of-use asset is subsequently measured at the amount of the lease liability, adjusted by the following factors:

  • Prepaid or accrued lease payments,
  • the remaining balance of any lease incentives received,
  • unamortized initial direct costs,
  • and impairment losses.

This measurement can be achieved by determining amortization as difference between the single periodic lease expense and the interest expense. The single periodic lease expense represents the allocation of the lease payments and initial direct costs on a straight-line basis over the lease term.

Lessee accounting – Presentation

For finance leases, interest expense is presented separately from the amortization of the right-of-use asset in the income statement. For operating leases, the single periodic lease expense is presented that includes amortization and interest expense.

Liabilities and right-of-use assets from finance leases must be presented separately from liabilities and right-of-use assets from operating leases on the balance sheet.

Separation of lease components from non-lease components

The new lease accounting standard ASC 842 contains guidance for the separation of lease components and non-lease components (e.g. service components) that are included in a lease as well as guidelines concerning the allocation of the consideration in the contract to these components.

As a practical expedient, lessees may choose not to separate non-lease components from lease components and account for such components as a single lease component. In case the lessee decides to separate lease components from non-lease components, the lessee is required to allocate the consideration in the contract based on the relative stand-alone price of the components (in line with ASC 606).

Lease reassessments

ASC 842 includes additional requirements for the reassessment of the lease term. If a triggering event occurs that is under the lessee’s control or an option is exercised or not exercised, the lease term has to be reassessed by the lessee. This results in a reassessment of the lease classification and a remeasurement of the lease liability and right-of-use asset.

On the remeasurement date, the discount rate and variable lease payments based on a rate or index have to be reassessed as well. The lessee is required to monitor these triggering events on an ongoing basis. Under the previous guidance, reassessment was only required if a lease was modified or an option was exercised.

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