Until now, private companies may have been able to avoid implementing the new lease accounting standard, ASC 842. The standard — one of the most significant recent changes in accounting — was issued in 2016 and has already gone into effect for public companies. However, the Jan. 1, 2022 deadline for private companies is now fast approaching, and the switchover will not be easy. The transition will likely be a meticulous, time-consuming, and complicated process, as the new standard directly impacts how organizations should account for leases. But the substantial accounting changes are not the only reason why private companies must start preparing now to comply with the new standard.

ASC 842 requires organizations to record all leases on their balance sheet, which will come with a significant financial statement impact. Our resource provides a quick overview of what to expect so your company can be better prepared for its new reporting obligations.

The Role Lease Classification Plays in Financial Reporting

Under the new standard, lessees must classify a lease as either a finance lease—previously a “capital lease”—or an operating lease. All lessors must classify a lease as a sales-type, direct financing, or operating lease.

For lessees, finance leases have one of the following characteristics:

  • It allows for the ownership to transfer to the lessee at the end of the lease term.
  • It contains a purchase option that is reasonably certain of being exercised.
  • The lease term is for the major part of the remaining economic life of the underlying asset. (Greater than or equal to 75% of the estimated economic life of the asset is a reasonable approach.)
  • The present value of the lease payments, and any residual value guaranteed by the lessee not already included in the lease payments, is greater than or equal to substantially all of the fair value of the underlying asset. (Greater than or equal to 90% of the asset’s fair value is a reasonable approach.)
  • It is a specialized asset with no alternative use.

Lessors will consider a lease as a sales-type lease if their lease meets at least one of above five criteria.

For a lessor, if none of the criteria above apply, but both of the following criteria are met, the lease is a direct financing lease:

  • The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already included in the initial measurement of the lease payments and/or any other third party unrelated to the lessor is greater or equal to substantially all of the fair value of the underlying asset, and
  • It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

Lessors must classify all leases that do not meet the definition of a sales-type lease or direct financing lease as an operating lease. Lessors are also required to classify and account for a lease with variable lease payments that do not depend on a reference index or a rate as an operating lease even if the lease otherwise would have been classified as a sales-type lease or a direct financing lease and the lessor would have otherwise recognized a day-one loss.

The type of lease a lessee or lessor has will affect how it appears within the financial statement. Lessees and lessors also have slightly different reporting requirements, explained further below.

Lessee Financial Statement Differences    

ASC 842 affects balance sheets, income statements, and statements of cash flows.

For balance sheets, changes to expect, regardless of lease classification are:

  • The lessee must record a right-of-use asset and disclose it in the footnotes if included in a line item with other assets.
  • Finance and operating right-of-use assets are prohibited from being included in the same line item.
  • The lessee must record a lease liability separately from operating (or finance) lease liabilities and disclosed in the footnotes if included in a line with other liabilities. It must be presented as current and noncurrent in a classified balance sheet.

For an income statement, here are the critical differences between finance leases and operating leases:

ASC 842 Impact on Lessee Income Statements

Provision Finance Lease Operating Lease
Interest & Lease Expense Interest expense is determined using the effective interest method. Lease expense is recorded usually on a straight-line basis over the lease term by adding interest expense determined using the effective interest method to the amortization of the right-of-use asset.
Amortization Amortization is recorded on the right-of-use asset (usually on a straight-line basis). The periodic expense at the beginning of the lease term will generally be greater than the corresponding cash payments but will decline over the lease term as the lease liability is reduced. Amortization of the right-of-use asset is calculated as the difference between the straight-line expense and the interest expense on the lease liability for a given period.
Presentation
  • Interest and amortization expense should generally be presented separately in the income statement in a manner consistent with the presentation of depreciation and amortization of similar assets and interest expense.
  • Lease-related amortization and lease-related interest expense cannot be combined in the same line item.
Lease expense is presented as a single line item in operating expense in the income statement (within continuing operations).

For both finance and operating leases, the right of use asset is tested for impairment in accordance with ASC 360.

Here are the critical differences for statements of cash flows:

ASC 842 Impact on Lessee Statement of Cash Flows

Finance Lease Operating Lease
  • Repayments of principal are classified as financing activities
  • Interest on the lease liability is classified in accordance with guidance related to interest in ASC 230
  • Variable lease payments are classified as operating activities
  • Operating lease payments, including variable lease payments, are classified as operating activities
  • Operating lease payments that are capitalized as a cost bringing another asset to intended use are classified as investing activities

For both finance and operating leases, initial recognition of the lease liability and right-of-use asset is disclosed as a non-cash transaction.

Lessor Financial Statement Differences

As with lessees, lessors also have significant changes when it comes to statement reporting:

ASC 842 Impact on Lessor Finanical Statements

Statement Sales-type Lease Direct financing lease Operating Lease
Balance Sheet
  • The underlying asset is derecognized and the net investment in the lease (the sum of the present value of the future lease payments and unguaranteed residual value) is recorded
  • The net investment in the lease is subject to classification as current or noncurrent assets in a classified balance sheet
  • The net investment in the lease is increased by interest income and decreased by payments collected
  • The underlying asset remains on the balance sheet
  • The underlying asset continues to be depreciated over its useful life, which could extend beyond the lease term
Income Statement
  • Selling profit or loss is recorded at lease commencement
  • Interest income is recorded based on the effective rate of interest in the lease
  • Selling profit is deferred and selling loss is recorded at lease commencement
  • Interest income is recorded based on the effective rate of interest in the lease
 Lease revenue and depreciation expense are presented on a gross basis in the income statement
Statement of Cash Flows Cash receipts from all leases are classified as operating activities except for certain financial institution entities

Next Steps

As you take the steps into this ASC 842 transition process, don’t hesitate to reach out to an accounting professional who can advise you on how to best comply with your new reporting requirements.

Published on November 15, 2021