This article has been written by Prabhudas Laxman Gaikwad, pursuing the Executive Certificate Course in US Accounting and Bookkeeping Course from Skill Arbitrage, and edited by Koushik Chittella.

Introduction

Lease accounting standards have experienced considerable transformations in recent years, reshaping the way companies disclose their lease responsibilities and assets in financial statements. The implementation of fresh standards, notably under the Generally Accepted Accounting Principles (GAAP) in the United States, has triggered a fundamental re-evaluation of how leases are handled from the viewpoints of both lessees and lessors. This article delves into the complexities of lease accounting standards within US GAAP, examining the fundamental principles, disclosure obligations, and their business ramifications. 

ASC 842

The Lease Accounting Standards are simplified as ASC 842, as it is a new accounting standard for entities reporting. It takes longer than 12 months to be recorded on the balance sheet under US GAAP. It is published by the Financial Accounting Standards Board, and it also governs how the entities record the financial impact of such lease agreements. Under US GAAP, the Financial Accounting Standards Board (FASB) introduced Accounting Standards Codification (ASC) Topic 842, Leases, replacing the former standard, ASC 840. ASC 842 aims primarily to enhance transparency and comparability among organisations. It achieves this by mandating the recognition of lease assets and liabilities on the balance sheet for most leases, offering users of financial statements a more comprehensive view of a company’s financial status.

ASC 842: meaning and requirements

It is a replacement for the previous lease accounting standard, ASC 840, and we need to record all the required leases on the balance sheet, irrespective of whether they are classified as operating or capital leases. The lease qualifies under ASC842 because

• The asset must be a physical asset.
• The right to control or use the asset must exist with them.
• It must be identified, explicitly or implicitly.

It requires all public and private entities and their financial statement users, who are typically investors or banks reporting to FASB under US GAAP, to record majority of their leases on the balance sheet. ASC 842 lease accounting, which replaces ASC 840, which sorted certain leases that were not capitalised on the balance sheet, we called it ‘Operating Leases’. Those were excluded from the vast financial analysis ratio, such as the “current ratio.” The exclusion of these could change the mindset and understanding of investors towards the lack of a company’s performance. 

Key Principles of ASC 842

Recognition of Lease Assets and Liabilities

Under ASC 842, lessees are mandated to acknowledge lease liabilities, reflecting forthcoming lease payments, alongside corresponding right-of-use (ROU) assets on the balance sheet for the majority of leases. This is irrespective of their prior classification as operating or finance leases. Lease liabilities are calculated as the present value of lease payments, while initially, ROU assets are determined based on the lease liability amount, adjusted for initial direct costs, lease incentives, and any prepaid or accrued lease payments.

Lease Classification

ASC 842 maintains the differentiation between finance leases (previously capital leases) and operating leases; however, it introduces fresh criteria for lessees to ascertain lease classification. These criteria encompass the transfer of ownership, the presence of a purchase option, and the lease term concerning the asset’s economic life.

Reporting Requirements under ASC 842

ASC 842 establishes thorough reporting obligations for both lessees and lessors, with the objective of furnishing users of financial statements with extensive insights into lease transactions and their effects on financial performance and standing. Essential reporting mandates encompass:

1. Balance Sheet Presentation: Lessees must distinctly present lease liabilities and ROU assets on the balance sheet, offering transparency regarding the extent of lease obligations and the associated right to utilise leased assets.
2. Income Statement Presentation: Lessees are obligated to record lease expenses in the income statement, usually comprising amortisation expense for ROU assets and interest expense on lease liabilities. This method diverges from the previous approach under ASC 840, where operating lease expenses were recognised evenly over time.
3. Disclosures: ASC 842 requires comprehensive disclosures aimed at aiding users of financial statements in comprehending the nature, timing, and uncertainty of cash flows stemming from lease transactions. These disclosures encompass both qualitative and quantitative details regarding lease obligations, terms, variable lease payments, and lease-related assets and liabilities.

Implications for Businesses under ASC 842

The adoption of ASC 842 brings substantial consequences for businesses, necessitating a re-evaluation of their lease accounting practices, systems, and procedures. Several key implications include:

1. Improved Transparency: ASC 842 elevates the transparency surrounding lease-related obligations and assets, empowering stakeholders to make better-informed decisions regarding a company’s financial well-being and performance.
2. Operational Adjustments: Businesses might necessitate alterations to their lease administration, accounting, and reporting processes to adhere to ASC 842 requirements effectively.
3. Financial Statement Consequences: The capitalization of lease assets and liabilities as per ASC 842 could impact crucial financial metrics like leverage ratios, return on assets, and earnings before interest, taxes, depreciation, and amortisation (EBITDA), potentially influencing credit ratings and investor sentiments.

Example: When accounting for ‘Operating Lease’ under ASC842, the lessee must: We must recognise a single lease cost on a straight-line basis and group all cash payments under operating activities on the cash flow statement. For instance, here is an example of the beginning of an operating lease post-transaction.

• Payment terms: $40,000 annually
• Start Date: 01/02/2023
• End Date: 31/01/2027
• Incremental Borrowing Rate (IBR): 3%
• The lessee determines this is an operating lease

Based on this case, the present value of 4 annual payments of $40,000 made in advance with a 3% IBR is $42,497.91. The operating lease expense is $40,000; it is 4 annual payments with no increase to counteract a perceived discrepancy or increment, rent holidays, etc.

Financial Leases

Finance leases have characteristics that are similar to those of purchasing an underlying asset. Different effective dates for the new release of the accounting standard for private and public companies are given by FASB. For the public, reporting periods began on December 15, 2018, and on January 1, 2019, the standard was adopted for calendar year-end companies. For private and non-profit organisations, it begins after December 15, 2021, for annual reporting. IFRS16, GASB87, GASB96, & ASC842 are interlinked with each other while we search for lease accounting standards under US GAAP. Lease accounting is the most important part of US GAAP because it can impact businesses if it falls under the rules of the lease accounting standard.

Here are some examples of accounting standards under US GAAP

1. Revenue Recognition (ASC 606): This standard delineates the principles governing the recognition of revenue derived from contracts with customers. It offers direction on the timing of revenue recognition and the methodologies for its measurement, with the objective of accurately portraying the transfer of goods or services to customers at a value representing the consideration anticipated by the entity.
2. Inventory Valuation (ASC 330): ASC 330 offers direction on how to value, measure, and present inventory in financial statements. It encompasses guidelines for establishing the cost of inventory, such as the lower of cost or market value, and methodologies for distributing costs, such as first-in-first-out (FIFO) or weighted-average cost.
3. Property, Plant, and Equipment (ASC 360): ASC 360 dictates the accounting procedures for property, plant, and equipment. It offers direction on the initial acknowledgment, valuation, depreciation, impairment, and disposal of these assets. Top of Form, Bottom of Form
4. Depreciation: Assets classified under PP&E are depreciated over their useful lives. The chosen depreciation methods should reflect the pattern in which the asset’s future economic benefits are expected to be consumed.
5. Financial Instruments (ASC 825): ASC 825 furnishes instructions on the acknowledgment, assessment, and disclosure of financial instruments. It encompasses diverse categories of financial instruments, such as cash, investments, derivatives, and debt securities, elucidating the criteria for their categorization and valuation.
6. Contingencies (ASC 450): ASC 450 focuses on the accounting procedures concerning contingencies, which are potential events that may lead to gains or losses contingent on future occurrences. It mandates entities to record a liability when a contingency is probable and its amount can be reasonably estimated, along with disclosing information about notable contingencies that are reasonably possible.
7. Impairment & Disposal: ASC 360 mandates that companies review PP&E for impairment whenever events or changes in circumstances suggest that the carrying amount may not be recoverable. If an asset is determined to be impaired, an impairment loss must be recognised. Guidelines are provided for the disposal of PP&E, which include removing the asset’s carrying amount from the balance sheet and recognising any resulting gain or loss.

These are merely a handful of instances of accounting standards within US GAAP, and there are numerous others encompassing a wide array of financial reporting and disclosure topics.

Lessor vs. Lessee

A lease agreement is a contractual arrangement between two parties regarding the use of a property or asset. The two parties are the lessor and the lessee.

1. A lessor can be a party that owns the property or asset and grants the rights to use or occupy it to another party, known as the lessee, in exchange for certain payments. In similar terms, the lessor is the landlord or owner of the property who allows someone else to use it for a specified period and under specific terms outlined in the lease agreement. The lessor retains ownership of the property but gives up possession temporarily.
2. The lessee is the party that receives the right to use or occupy the property or asset owned by the lessor. They are the tenants or users of the property. The lessee agrees to make regular payments as rent to the lessor for the privilege of using the property. This will be according to the terms outlined in the lease agreement. The lessee does not own the property but has the right to use it during the lease term.

Conclusion

In summary, the landscape of lease accounting standards within US GAAP has undergone substantial transformation with the advent of ASC 842, compelling businesses to embrace a heightened level of transparency and uniformity in lease accounting and reporting. Through the recognition of lease assets and liabilities on the balance sheet and the provision of comprehensive disclosures, ASC 842 endeavours to enhance the calibre and comparability of financial data, thereby empowering stakeholders to make well-founded decisions. It is imperative for businesses to actively tackle the challenges and ramifications of ASC 842 to uphold compliance standards and sustain stakeholders’ trust and assurance in their financial disclosures.

References

1. https://kpmg.com/us/en/articles/2022/lease-accounting-ifrs-standards-us-gaap.html
2. https://www.leasecrunch.com/blog/asc-842
3. https://finquery.com/blog/asc-842-summary-new-lease-accounting-standards
4. https://www.icaew.com/technical/by-country/north-america/us/accounting-in-us/us-gaap