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ASC 842 lease accounting standards: finance and operating leases

11.22.19

Editor’s note: read this if your organization is an entity with significant lease transactions with terms greater than a year.  

The new Accounting Standards Codification Topic 842 (ASC 842) lease accounting standard is actually not that new. The Financial Accounting Standards Board (FASB) first released the standard in 2016 but, due to a series of delays, it hasn’t been required yet. Even with delays, some organizations have already started to implement ASC 842. They include:

  1. Public business entities
  2. Not-for-profits that have has issued or are conduit bond obligors for securities traded, listed, or quoted on an exchange or an over the-counter market

All other entities will start implementing for fiscal years starting after December 15, 2020 and interim periods within fiscal years beginning after December 15, 2021 (January 1 for calendar reporting periods).

Here’s a quick rundown of the lease classifications and how they’ll impact your financial statements.  

Classifying Leases

Under the new standards, leases fall into one of two classifications: finance leases and operating leases. This classification makes all the difference in how leases are reported in the financial statements. 

Finance lease

A finance lease essentially treats an asset as if it were purchased by the lessee and financed with funds from the lessor. This prevents companies from hiding financial obligations that are basically liabilities. ASC 842 requires leases to be classified as finance leases if they meet any of the following five criteria:

  1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
  2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
  3. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
  4. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
  5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

As you can see from the five criteria, finance leases are just purchase arrangements financed over time. ASC 842 is designed to reflect that and improve transparency for investors and other stakeholders.  

Operating lease

Any lease not meeting any of the above criteria is classified as an operating lease. 

No more off-book leases

One of the problems ASC 842 seeks to solve is “off-book” operating leases that show up only as notes on the balance sheet and cloud the debt ratios of companies. Under the new standards, both operating and finance leases will be reported on the balance sheet. The only exceptions are certain leases with terms of 12 months of less. 

Recording finance vs. operating leases

With both operating and finance leases reported on the balance sheet, what’s the difference between the two? The major difference is the way they are recorded on the income statement:

  • Interest and amortization are recorded separately on the income statement for finance leases.
  • Operating leases will report a single line item based on the lease payment. 
  • Principal repayments for finance lease are classified as financing activities.
  • Payments on operating leases are classified as operating activities.

Next Steps 

Make sure you start by implementing for fiscal years starting after December 15, 2020 and interim periods within fiscal years beginning after December 15, 2021. If you have questions about finance or operating leases, or need help with the new standard, please don’t hesitate to contact the team
 

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