ASC 842 Summary

Texas Southern UniversityJHJ College of Business

Structural Accounting Theory ACCT 650

Dr. Richard PitreSummary of ASC 842 on Lease

Accounting Update

Student’s Name:

Thanh K. Le1

ASC 842 Summary

According to the 2005 SEC report on off-balance sheet activities, there are $1.25 trillion

of off-balance sheet operating lease commitments for SEC-registered companies. That number

has been increasing since then. This fact represents a material insufficiency of faithful

representation of actual lease assets and lease liabilities, especially with operating lease category

(failure of all four tests: at least 75% of useful life lease length, at least 90% of fair value,

bargain purchase option, and ownership transfer). FASB’s guidance on lease accounting used to

only require capital(finance) lessees, not operating lessees, to recognize lease asset and lease

liabilities in the balance sheet. To increase transparency and usefulness of lease accounting on

financial statements, in February 2016, FASB issued accounting standard update ASC 842 on

new lease accounting rules.

The main update, compared with previous GAAP provision, is the recognition of lease

assets (deemed as right to use) and liabilities (present value of lease payments) by lessees for

OPERATING leases (for longer than 12-month lease). It also maintains distinction between

finance (capital) lease and operating lease. In fact, ASC 482 provides new guidance on lessee

accounting, lessor accounting, capitalization spectrum, classification timing, new test for capital

lease, fair value adjustment, residual value recognition, sublease accounting, definition of a

lease, lease versus non-lease component separation, sale-leaseback transactions, disclosures, and

lease transition.

Once again, the heart of ASC 842 is lessee must recognize all lease assets and liabilities

under both operating and capital lease. This recognition is in parallel with FASB Concepts

Statement No. 6, Elements of Financial Statements, and it provides improvements over previous

GAAP guidance. A liability to make lease payments (the lease liability) and a right to use asset

(the lease asset) are the main recognitions on the balance sheet. Notably, optional payments to

2

ASC 842 Summary

purchase the leasing assets should be attributed into the measurement of lease assets and

liabilities only if lessee is reasonably certain to exercise the purchase option. In addition, both

lessee and lessor should exclude most variable lease payments in measuring lease assets/

liabilities, other than ones depending on index or fixed payment rates. What is also noteworthy is

ASC 482 does not put asset/liability recognition requirement on less-than-12-month (short term

lease). In other words, in short term lease, lessee is allowed to carry out accounting policy not to

recognize lease assets and liabilities. However, lessee still need to recognize lease expense on

straight-line basis over the lease term.

As previously mentioned, for both operating and capital lease, lessee is required to

recognize right to use asset and present value of lease payment liability in the balance sheet.

However, for operating lease, lessee recognizes a single lease cost, allocated on straight-line

basis over the lease term, and then classify all cash payments in the operating activities in the

statement of cash flows. On the other hand, for capital lease, lessee recognizes interest on the

lease liability separately from the amortization of the right to use asset in the statement of

comprehensive income, and then classify repayment of principal portion of lease liability in the

financing activities of the statement of cash flow and payment of interest of lease liability/

variable lease payments within the operating activities.

From the perspective of lessor accounting, there are fewer changes from previous GAAP.

Most of operating leases will still be classified as operating leases, and lessors should continue to

recognize lease income on straight-line basis over the lease term. However, there are two

changes in lessor accounting guidance. First, ASC 842 requires clarity in the disclosure of

glossary terms that affects a lessee applying the lessor guidance upon the sub-lessor. It ensures

all parties apply the same terms. Secondly, ASC 842 requires revenue recognition guidance from

3

ASC 842 Summary

lessors must align with ASC 606. For example, lessor accounting guidance for real estate assets

must conform with GAAP framework of risk-and-rewards principle for determining whether

sales of asset occur. Mostly, sale classification is established when lessee obtains the control of

the underlying asset. On the other hand, in the absence of control transfer of underlying asset,

lessor is precluded from recognizing profit or revenue at least commencement. Last but not least,

ASC 842 does not distinguish between the leases of real estate and ones of other assets.

According to a summary note from LeaseQuery, a credible lease accounting management

software, besides updates on lessee accounting and lessor accounting, capitalization spectrum is

also another area of changes. Under previous GAAP, all executory costs, such as tax payments or

taxes are excluded from the lease liability. Such exclusion often resulted in “minimum lease

payments”. ASC 842 allows “full lease payment” capitalization including executory costs which

enlarge the recognized liability.

Next, ASC 842 requires lease classification (operating or capital lease) to be determined

at the beginning of lease term, instead of at the end of the lease term (when the lease is

executed).

Additionally, ASC 842 adds a fifth test for eligibility for capital lease classification.

Beside the four traditional tests (75% of useful life, 90% of fair value from present value of lease

payment, ownership transfer, bargain purchase option), a test is created for highly specialized

assets. Under this new test, if the leased asset is so specialized that in the end, it has no

alternative usage to the lessor, the lease is considered a capital(finance) lease.

Furthermore, ASC 842 allows recognition of lease assets, using the appropriate discount

rate or implicit rate, even when the lease asset’s value exceed its fair value. As a result, such

4

ASC 842 Summary

lease asset will then be tested for impairment and written down to the fair value. This new

approach provides much more freedom than the previous GAAP rule that prohibited asset

recognition that exceeded its fair value.

Moreover, ASC 842 makes it mandatory to always use the implicit rate (if known), even

when it is greater than the incremental borrowing rate. However, in reality, it is very hard to

determine the implicit rate, therefore the trend lessee will keep using their incremental borrowing

rate to determine the lease liability. Overall, this provision is completely different from previous

GAAP guidance: usage of lesser of implicit rate or incremental borrowing rate.

Not less importantly, ASC 842 only allows the expected amount to be owed at the end of

the lease term to be included in the capitalized lease liability. It differs from previous GAAP rule

in that previous rule requires entire amount of residual value to be capitalized into lease liability.

Last but not least, LeaseQuery outlines updates on sublease accounting. Under previous

GAAP rule, the liability from the original lease can be netted against the sublease income.

However, under ASC 842, sublease asset/liability must be accounted separately from the original

lease. This new requirement will have majority of companies to change their sublease accounting

method which is still netting sublease and original lease asset/liability.

Back to core update of ASC 842, it actually allows the previous accounting model for

leveraged leases that started before the effective date of update to be continued. However, the

model for leverage leases commencing after the effective date of update (in ASC 840) can’t be

retained.

ASC 842 also clarifies the definition lease as a component of contract. In fact, it defines a

lease as a contract, or part of a contract, that transfer the right to control the use of identified

5

ASC 842 Summary

property, plant, equipment or other identified assets. The control over the use of such identified

assets means lessees (receivers) has both the right to obtain substantially all of the economic

benefits from the use of the asset and the right to direct the use of the asset. In fact, if a contract

containing lease or lease contract is established, it can be critically determined that lessee must

recognize lease assets and lease liabilities for both operating and capital lease.

Next, ASC 842 also enhance the guidance on how to identify and separate lease

components from non-lease components. Lease component is like the lease payment or lease

income. Non-lease component is like maintenance service. This separation enables lease contract

to be allocated to the lease and non-lease components on the price basis (for lessees) and on ASC

606 allocation guidance (for lessors). However, ASC 842 does allow entities to make an

accounting policy to combine lease and non-lease components as a single lease component.

ASC 842 also updates accounting for sale-leaseback transactions. As a prerequisite, the

transfer for lease asset must meet requirement for a sale in ASC 606 to be classified as sale-

leaseback transaction. Any consideration paid for the asset is accounted for as a financing

transaction by both seller-lessee and buyer-lessors. In addition, ASC 842 specifies if the

leaseback is classified as a finance/sales-type lease, no sales has occurred. Also if there is a

repurchase option from seller-lessee from buyer-lessor, sale accounting is prohibited unless the

assets is non-specialized and the exercise price of repurchase option is equal to the fair value of

the lease asset on the date of exercise.

ASC 842 also strengthen the disclosure effectiveness requirement for both lessees and

lessors. They are both required to provide useful disclosure (in both qualitative and quantitative

means) upon assessment of amount, timing, and cash flow from leases. Through this way,

6

ASC 842 Summary

investors, creditors, and analysts can understand more about the nature of entity’s leasing

activities.

ASC also requires that in transition, both lessees and lessors need to recognize and

measure leases at the beginning of the earliest period presented using a modified retrospective

approach. This approach can be manifested as either identification/classification of leases

commencing before effective date of update, initial direct costs for leases commencing before

effective date, and using hindsight to evaluate lessee options to either extend or terminate a lease

to purchase underlying asset.

ASC 842 will definitely affect a large scale of entities that are currently having leases in

their current operations, especially lessees for operating lease. These entities depend on lease as a

mean to access the underlying asset, to acquire financing, to generate additional lease revenue, or

to reduce risk from owning the asset. They need to adjust their internal accounting system and

internal control to adequately adapt to new requirements. External auditors also need to establish

new materiality tests on lease-related transactions to ensure no misstatement on financial

statements. The good news is constituencies have time to prepare for these changes. In specific,

public business entity, not-for-profit entity (having bonds obligation for traded securities), and

SEC-registered employee benefit plan must implement ASC 842 for the fiscal year beginning

after December 15th, 2018, including interim periods within such fiscal year. For all other

entities, updates are to implemented for fiscal years beginning after December 15th, 2019 and for

interim periods within such fiscal year beginning after December 15, 2020.

On a side-note, ASC 842 also possesses key differences from IFRS 16 update. These

differences are highlighted in a PwC’s April 2016 Comprehensive Guide to Lease Accounting

Update. One example is from lessee accounting. ASC 842 requires a lessee to classify a lease as

7

ASC 842 Summary

either as capital or operating lease. Interest and amortization expense are recognized for capital

lease, while only a single lease expense is recognized for operating leases, on straight-line basis.

Under IFRS, lessees will account for all leases in the fashion of capital lease.

Another example pertains to lessor accounting. Under ASC 842, a sale and profit are

recognized upon the start of a lease only when there is a transfer of control over the underlying

assets to the lessee. Under IFRS 16, selling profit is recognized on direct financing leases when

performing obligations in IFRS 15 (Revenue from Contracts with Customers) have been

satisfied. There are other differences between ASC 842 and IRFS 16 in lease update effect on

statement of cash flows, re-measurement of variable lease payments, sale-leaseback accounting,

transition leasing accounting, and sublease accounting.

8

ASC 842 Summary

References

"FASB, Financial Accounting Standards Board." Proposed Accounting Standards Update-Leases (Topic 842). FASB, n.d. Web. 20 Sept. 2016.

"Key Differences Between Current GAAP and The New Lease Standard - LeaseQuery." LeaseQuery. N.p., 01 June 2016. Web. 20 Sept. 2016

"Lease Guide - 2016 Edition." PwC's Comprehensive Guide to the New US GAAP Leases Guidance. PwC, 11 Apr. 2016. Web. 20 Sept. 2016.

9