For non-public companies, Accounting Standard Update (ASU) 2016-02, Leases (codified as ASC 842) becomes effective for year-ends beginning on or after December 15, 2021. ASC 842 will cause significant changes in accounting for leases for both lessees and lessors as outlined below:
Key changes for lessees-
Capital leases, now referred to as finance leases, were reported on the balance sheet and within the financial statement footnotes under prior guidance. Operating leases were present solely within the footnotes. ASC 842 will require both finance and operating leases to be disclosed on the balance sheet unless an exclusion exists. Lessees will continue to evaluate and treat leases as either operating or finance. ASC 842 changes the evaluation model from four criteria to five criteria along with some adjustments within the evaluation criteria.
Key changes for lessors-
ASC 842 will require lessors to evaluate contracts to determine lease and non-lease components. Lease components will be subject to revenue recognition under ASC 842 depending on the type of lease: sales-type lease, direct financing lease, or operating lease. The non-lease components would be subject to revenue recognition under ASC 606 unless a practical expedient is elected. Under ASC 842, lessors will adopt the new five criteria evaluation model to determine sales-type leases.
Identification of Leases and Key Estimates and Assumptions
The first step in implementing ASC 842 is to determine what leases are in place for the organization. The main question to ask is, "does a lease exist."
There are three main components of a lease:
1. the ability to control or direct the use of a piece of property or equipment;
2. a specific term over which the organization has control of the property and equipment;
3. consideration is due to another party for the control of the property or equipment.
Under ASC 842, the determination of leases and the associated estimates and assumptions will be performed at inception. An organization must re-evaluate the accounting treatment if a modification to the lease or contract occurs or a change in significant assumption.
One of the difficulties organizations will have when implementing ASC 842 is reviewing contracts or lease agreements with multiple components. An organization must perform an evaluation to determine the lease or non-lease components.
An example of multiple components is a contract that includes rental space (a lease component) and common area maintenance (a non-lease component). To determine whether a separate lease exists, there are two primary questions to review.
The first question is whether an organization can benefit from using the asset on its own or with readily available resources?
The second question is if the underlying asset is highly dependent or interrelated with other assets within the contract. A separate lease can be utilized independently and will not be highly dependent on other assets within the contract.
Once the total population of lease arrangements is identified, the following steps will determine the treatment under ASC 842.
First and foremost, an organization will determine the length of the lease, including the reasonable certainty of the exercise of a renewal option. This step is critical as it may cause certain leases that would otherwise be excluded under practical expedients to be includable.
A specific example of this is a lease with a base term of one year and a renewal option available for an additional year. The organization would treat this as a two-year lease if the renewal option were reasonably expected to be picked up. As an assumed two-year lease, this lease would be subject to ASC 842.
The next estimate that will be performed is the allocation of consideration between the lease and non-lease components. For lessors, this allocation is critical as the lease, and non-lease components may have different revenue recognition timing.
The final step that must be performed with leases is the determination of the type of leases. For lessees, this will be between operating and finance. For lessors between sales-type, direct financing lease, or operating lease. For lessees, both operating and finance leases will be recorded on the balance sheet similarly. The main difference will be expense recognition. An organization recognizes an operating lease on a straight-line basis over the life of the lease term through lease expense. An organization recognizes a finance lease on an amortized basis through interest expense and lease expense. Given similar starting liabilities, a finance lease results in greater expense earlier in the life of the lease. For lessors, the type of lease can lead to dramatic differences in both the balance sheet treatment and the income statement treatment. However, the treatment under ASC 842 is consistent with ASC 840.
Determination of the Type of Lease
As noted earlier, ASC 842 expands the prior guidance under ASC 840 from four criteria to five criteria and modifies some from the previous guidance. The table below will break out the five criteria as well as what has changed from ASC 840.
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Criteria |
Change from prior guidance |
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A transfer of ownership of the property occurs at the end of the lease |
No change from prior guidance |
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There is a reasonable certainty that a lessee will exercise a bargain purchase option at the end of the lease. |
Prior guidance referenced only the existence of the bargain purchase option. |
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The lease term is for a major part of the remaining life of the underlying asset. |
Prior guidance referenced a useful life of 75% |
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The present value of the sum of the lease payments and guaranteed residual value equals or exceeds all the fair value of the underlying asset substantially. |
Prior guidance referenced 90% as the value to exceed |
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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 |
New guidance in ASC 842. |
Journal Entries Required Under ASC 842
The journal entries required for finance leases and leases for lessors did not change significantly because of ASC 842. For operating leases, there will be significant changes from prior guidance.
ASC 842 requires the use of the modified retrospective approach for adoption concerning existing lease obligations. The organization will record existing leases as of the earliest period presented and through the comparative periods or as of the effective date with a cumulative-effect adjustment to equity. The journal entry will be in line with entry number one below.
Assuming a new lease in the year of the adoption of ASC 842, there will be two primary journal entries.
1. Record a lease liability and an offsetting right-of-use asset for each operating lease subject to ASC 842.
Debit: Operating Lease Right of Use Asset
Credit: Operating Lease Liability.
The organization records the entry based on the present value of the future lease payments for the operating lease.
The present value calculation requires the organization to come up with a discount rate. The discount rate to utilize will be one of three choices:
1. the rate implicit in the lease agreement
2. the lessee's incremental borrowing rate or
3. for non-public companies, a measure of the risk-free rate of return (i.e., the US Treasury rate).
To calculate the net present value in Microsoft Excel, utilize the "=PV" formula. The inputs will be the discount rate chosen, the number of payments, the payment required, any future value [as applicable], and the timing of the payment. The formula assumes a payment is due at the end of the period, and a "1" must be added for payments due at the beginning of the period.
2. Record the annual lease payments and expenses.
Debit: Lease Expense
Debit: Operating Lease Liability
Credit: Cash
Credit: Operating Lease Right-of-Use Asset
The lease expense and cash portion of the entry will be based on the annual payment amount. In this example, the entry was for an annual journal entry, but these amounts can be recorded monthly as the associated lease payments are made. The portion of the entry relating to the operating lease liability and operating lease right-of-use asset will be based on the annual amortization of the present value amount. An amortization table can be created within excel to track the annual entry to be made.
Practical Expedients
The steps and entries above will require significant resources in the year of adoption and future reporting periods. As a result, there are several practical expedients to consider that may lessen the burden of adopting ASC 842.
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Practical Expedient |
Additional Considerations |
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An organization may elect as an accounting policy to not record leases with terms of 12 months or less on the balance sheet. |
Organizations must evaluate whether renewal terms are reasonably certain to be exercised to make the term greater than one year. |
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An organization can create a capitalization threshold for when leases will be capitalized. |
The determination of the capitalization threshold must ensure that leases not capitalized on the individual and aggregate basis would not be material to the financial statements. |
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For lessees, the entire lease and non-lease components can be treated as a lease in lieu of the allocation of consideration amount for the two components. |
Treating the lease and non-lease as a single lease will result in a higher liability recognized on the balance sheet. |
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For lessors, the lease and non-lease components may be considered a single revenue stream. The revenue stream will require evaluation for which revenue recognition criteria to utilize ASC 842 or ASC 606. |
To utilize this approach, the non-lease component must have similar timing of recognition to the lease component. In addition, the lease must be an operating lease. |
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For non-public entities, the risk-free rate of return may be used for all leases in lieu of calculating a separate discount rate. |
The risk-free rate of return will traditionally be lower than the calculated discount rate resulting in a higher liability on the balance sheet. |
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Upon adoption, an organization can use current hindsight in determining lease terms and any impairment in right-to-use assets. |
Right-to-use assets will need to be evaluated for potential impairment. |
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For leases in effect before the effective date of ASC 842, an organization can - Not reassess whether a contract is or contains a lease. - Not reassess the lease classification between operating and finance. - Not reassess initial direct costs. |
All three components must be adopted for all leases. The prior guidance under ASC 840 must have been appropriately applied in the preceding year. |
How to Prepare for Adoption
The lease standard is effective for non-public entities with annual periods beginning on or after December 15, 2021. For calendar-year organizations, the accounting updates will not be reflected until the December 31, 2022, financial statements.
The steps below can be taken at the current moment to prepare for ASC 842 adoption.
1. Determine the current population of leases, including rental properties, office equipment, leases, etc.
2. Determine if a lease capitalization policy would be appropriate for the organization. If applicable, draft a formal lease capitalization policy.
3. Create a process to determine how contracts will be evaluated for lease components.
4. Create a process to determine how the likelihood of renewal terms will be treated. Organizations should consider different methods for different asset classes.
5. Create a policy to determine when a significant modification or change in assumption has occurred, which will require reassessment.
6. For lessees: create a policy on how the lease and non-lease components will be allocated in a standard transaction.
7. For lessors: document the election of how to treat lease and non-lease components. For the combined revenue stream, document the revenue recognition treatment.