Understanding ASC 842 Compliance

Accounting Standards Codification (ASC) 842 is effective for private companies for years beginning after 12/15/21, so for companies with calendar year ends, your 2022 financial statements will need to be compliant with ASC 842.

What Is Accounting Standards Codification 842 (ASC 842)?

Accounting Standards Codification (ASC) 842 requires capitalization onto the Balance Sheet of all leases with terms more than 12 months. The Financial Accounting Standards Board (or FASB) created this new standard to foster more transparency between investors and companies by moving information that was primarily in the footnotes in the past onto the Balance Sheet.

Overview of ASC 842

Under ASC 842, all leases are either considered financing (previously referred to as “capital”) or operating. The criteria for determination of a financing lease are the same as before:

  • Ownership transfers to the lessee at the end of the lease
  • There is a bargain purchase option at the end of the lease
  • The lease represents 75% of the asset’s useful life
  • The lease payments represent 90% of the asset’s fair value
  • There is no alternative use for the asset

Under ASC 842, companies must account for operating leases by recognizing a single lease cost allocated over the lease term, generally on a straight-line basis. All cash payments should be classified within the operating activities on the statement of cash flows. The lease asset is called a “right of use” asset and represents the total lease liability adjusted for certain items like prepaid rent or lease incentives.

The lease liability is measured as the present value of the lease payments over the term of the lease. Private companies cash use the risk-free rate as the discount rate as a practical expedient. This will simplify the calculations for private companies; however, it will cause higher lease liabilities.

When determining the term of an operating lease, companies should include reasonably certain lease renewals and purchase options. For example, if the lease is a month-to-month lease; however, the company is expected to continue to lease the asset for longer than 12 months. If the term is less than 12 months, companies can elect not to recognize the right of use of assets and corresponding liability but should recognize the lease expense on a straight-line basis.

Related Party considerations should also be addressed when determining the term of the lease under ASC 842. Determination should be based on implicit legally enforceable terms, and the classification should be the same as it would be for unrelated parties. Also, even if the lease is informal/verbal, it must be evaluated under ASC 842. Companies cannot get around ASC 842 by simply creating a month-to-month or annual lease with a related party.

If there are any implicit legally enforceable terms or conditions of a lease, management estimate of the lease term should be based on the implied intentions of the leased property.

An Example of ASC 842

A lessee leases a facility from a related party for five years with no option to renew. Significant costs are incurred by the lessee related to leasehold improvements that will retain significant value over a useful life of 20 years.

What do they need to consider?

  1. One should consider whether there are implicit legally enforceable terms and conditions that would result in the lease term needing to be evaluated as 20 years instead of 5 years. The existence of leasehold improvements in the leasing arrangement, absent a formal lease contract, may provide an indication of legally enforceable rights and obligations.
  2. Assuming the leasing arrangement will continue until the cost of the leasehold improvements has been fully amortized, companies may need to consider the amortization period for leasehold improvements when determining the lease term.
  3. However, there may be situations where there are minimal leasehold improvements or none, and the renewal option is annual. This will require more judgment in determining a reasonable estimate of the lease term.
  4. Also, things to consider may be how long the lessee has been in the facility and any plans to relocate. Are there cost constraints to relocation that could play into determining a lease term that exceeds an annual renewal?
  5. Last but not least, one may also consider the client’s strategic plan and if their facility accommodates planned expansion or other needs.

“Each of these considerations should influence management’s determination of the term of the lease under ASC 842.”

Components of ASC 842

Financial Statement Footnote Disclosures

When making financial statement footnote disclosures related to ASC 842, disclosures must be qualitative and quantitative. They should include:

  • Details surrounding the lease arrangements
  • Any significant judgments made concerning the lease term.
  • Total lease expense for the period
  • Weighted-average analysis of discount rates and remaining lease terms.

ASC 842 also requires companies to evaluate embedded leases which can be buried in other types of agreements such as service contracts, equipment rental agreements, manufacturing contracts, or transportation contracts. Components to consider when evaluating embedded leases are:

  • If the asset can be identified
  • If there is a right to control the asset
  • If the term is identified
  • If there is an exchange of consideration for the asset.

Not sure where you are in the implementation process? Here’s a readiness checklist:

  • First, identify your lease population – you’ll likely have more leases than what you can think of off the top of your head!
  • Next comes the technical analysis and assessment:
    • Will you use the Modified Retrospective Type 1 Method and apply ASC 842 to each reporting period presented, or
    • Will you use the Modified Retrospective Type 2 Method and apply ASC 842 as of the adoption date of January 1, 2022?
  • Then, it’s time to perform the lease calculations. For RBTK clients, we are recommending using specialized software for running these calculations to produce the most timely, effective, and cost-effective compliance with ASC 842.

If you’re a construction contractor, there are also several additional considerations to think about pertaining to banking and bonding.

The end of the year is approaching, and now is the time to reach out to us to discuss your upcoming implementation of ASC 842. Call us at 858-430-0300 today.