Fasb asc 842

What Is FASB ASC 842?

FASB ASC 842 is the current lease accounting standard issued by the Financial Accounting Standards Board (FASB) that dictates how organizations reporting under Generally Accepted Accounting Principles (GAAP) must record the financial impact of their lease agreements. This standard falls under the broader financial category of Accounting Standards, specifically focusing on lease accounting. Its primary objective is to enhance transparency for financial statement users by requiring companies to recognize most leases on their balance sheet, thus providing a clearer picture of their assets and liabilities.

History and Origin

Prior to the introduction of FASB ASC 842, a significant concern in financial reporting was the widespread practice of "off-balance-sheet financing" through operating leases. Under the previous standard, FASB ASC 840 (formerly FAS 13), many lease agreements were classified as operating leases and were not recorded on the balance sheet, only disclosed in the footnotes of financial statements. This obscured a company's true financial leverage and obligations, making it difficult for investors and other stakeholders to compare entities accurately¹⁷, ¹⁸.

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) initiated a joint project in 2006 to address these concerns and develop converged lease accounting standards¹⁶. After years of deliberation and multiple exposure drafts, the FASB issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), in February 2016¹⁴, ¹⁵. This landmark update significantly changed how lessees account for leases. Publicly traded companies were required to transition to FASB ASC 842 for fiscal years beginning after December 15, 2018 (effectively January 1, 2019, for calendar-year companies). Private companies and non-profit organizations received delays, with their effective date eventually set for fiscal years beginning after December 15, 2021¹², ¹³.

Key Takeaways

• FASB ASC 842 requires lessees to recognize both a right-of-use asset and a lease liability on the balance sheet for most leases with a lease term greater than 12 months.
• The standard distinguishes between two types of leases for lessees: finance leases (formerly capital leases) and operating leases.
• The primary goal of FASB ASC 842 is to increase transparency and comparability of financial statements by bringing lease obligations onto the balance sheet.
• Lessor accounting under FASB ASC 842 remains largely similar to the previous standard, with classifications as operating, sales-type, or direct financing leases.
• Implementation of FASB ASC 842 can significantly impact a company's financial ratios, internal controls, and data management processes.

Formula and Calculation

Under FASB ASC 842, the lease liability is initially measured as the present value of the remaining lease payments. The right-of-use asset is then measured at the amount of the lease liability, adjusted for any initial direct costs, lease incentives received, and prepaid or accrued lease payments.

The formula for the present value of lease payments is:

Where:

• (PV) = Present Value of Lease Payments (Lease Liability)
• (P_t) = Lease payment in period (t)
• (r) = The discount rate (either the rate implicit in the lease or the lessee's incremental borrowing rate)
• (t) = Period number
• (n) = Number of periods in the lease term

The right-of-use (ROU) asset is calculated as:

For subsequent measurement, a finance lease will have interest expense on the lease liability and amortization expense on the ROU asset recognized separately on the income statement. For an operating lease, a single, straight-line lease expense is recognized on the income statement, calculated to approximate a constant periodic expense over the lease term¹¹.

Interpreting the FASB ASC 842

FASB ASC 842 fundamentally alters how investors and analysts view a company's financial position, especially for those entities with significant leasing activities. By requiring nearly all leases to be recognized on the balance sheet, the standard provides a more comprehensive view of an entity's obligations and its right to use underlying assets.

For instance, previously "off-balance-sheet" operating leases now contribute to the total liabilities and assets, which can impact key financial ratios such as debt-to-equity and leverage ratios¹⁰. Understanding a company's lease portfolio under FASB ASC 842 means analyzing both the recognized right-of-use assets and lease liabilities, as well as the accompanying disclosures that provide qualitative and quantitative information about lease terms, options, and judgments made in applying the standard. This heightened visibility aims to allow for better capital allocation decisions and more accurate comparisons between companies, regardless of whether they choose to lease or purchase assets.

Hypothetical Example

Consider "Retailer X," which leases numerous storefronts across the country. Under the previous accounting standard (FASB ASC 840), many of these leases were classified as operating leases, meaning only the rent expense was recognized on the income statement, and no corresponding asset or liability appeared on the balance sheet.

With the adoption of FASB ASC 842, Retailer X must now recognize a right-of-use asset and a lease liability for each qualifying lease with a term over 12 months.

Scenario: Retailer X signs a new 5-year lease for a retail space with annual payments of $100,000, payable at the end of each year. The incremental borrowing rate for Retailer X is 5%.

Calculation under FASB ASC 842:

1. Calculate the Present Value of Lease Payments (Lease Liability):

   • Year 1: $100,000 / (1 + 0.05)^1 = $95,238.10
   • Year 2: $100,000 / (1 + 0.05)^2 = $90,702.95
   • Year 3: $100,000 / (1 + 0.05)^3 = $86,383.76
   • Year 4: $100,000 / (1 + 0.05)^4 = $82,270.28
   • Year 5: $100,000 / (1 + 0.05)^5 = $78,352.62
   • Total Present Value = $95,238.10 + $90,702.95 + $86,383.76 + $82,270.28 + $78,352.62 = $432,947.71

2. Recognize the ROU Asset: Assuming no initial direct costs, lease incentives, or prepaid rents, the initial right-of-use asset would also be $432,947.71.

Thus, Retailer X's balance sheet would reflect a new asset and a new liability, providing a more accurate representation of its economic commitments.

Practical Applications

FASB ASC 842 impacts virtually every entity that leases assets, from large multinational corporations leasing real estate and equipment to smaller businesses leasing vehicles or office space.

• Financial Reporting: The most direct application is in how companies prepare their financial statements. The standard mandates the capitalization of nearly all leases on the balance sheet, affecting reported assets, liabilities, and potentially equity⁹.
• Credit Analysis: Lenders and credit rating agencies now have a more complete picture of a company's off-balance-sheet obligations, which can influence credit risk assessments and borrowing costs.
• Mergers and Acquisitions (M&A): Due diligence in M&A transactions now involves a more thorough analysis of lease portfolios, as these obligations are explicitly recognized.
• Strategic Decision-Making: Companies may re-evaluate their leasing strategies versus purchasing assets, considering the balance sheet impact of FASB ASC 842. The change in accounting treatment highlights the economic reality of lease commitments⁸.
• Tax Implications: While FASB ASC 842 significantly changes financial reporting for GAAP purposes, it generally does not directly impact federal income tax treatment of leases⁷.

Companies must develop robust internal processes for identifying, collecting, and managing lease data to comply with FASB ASC 842 effectively, often leveraging specialized lease accounting software⁶. Publicly traded companies, in particular, must ensure their filings to the SEC.gov accurately reflect the requirements of the standard.

Limitations and Criticisms

Despite its aim to improve transparency, FASB ASC 842 has faced certain criticisms and presented implementation challenges.

One common critique revolves around the complexity and significant administrative burden associated with compliance, particularly for companies with a large volume of diverse lease agreements⁵. Identifying all lease contracts, including embedded leases within service agreements, and collecting the necessary data for each, such as lease terms and discount rates, can be time-consuming and resource-intensive⁴.

Another point of contention is that while the standard brings operating lease obligations onto the balance sheet, the resulting right-of-use asset is a conceptual asset representing the right to use, rather than outright ownership of, the underlying physical asset. Some argue that this can still complicate the interpretation of a company's true asset base³. Furthermore, the distinction between finance and operating leases remains for lessees under FASB ASC 842, leading to different income statement and cash flows impacts, which some believe still reduces comparability compared to the converged International Financial Reporting Standard (IFRS 16), which eliminated this distinction².

FASB ASC 842 vs. FASB ASC 840

The key difference between FASB ASC 842 and its predecessor, FASB ASC 840 (formerly FAS 13), lies in the balance sheet recognition of operating leases.

The primary confusion between the two arises from the continued use of "operating lease" terminology, even though under FASB ASC 842, operating leases now result in balance sheet recognition for lessees. The intent of FASB ASC 842 was to ensure that a company's full economic commitment to leased assets is visible to financial statement users.

FAQs

What is the main goal of FASB ASC 842?

The primary goal of FASB ASC 842 is to improve the transparency and comparability of financial statements by requiring companies to recognize most lease liabilities and corresponding right-of-use assets on their balance sheet, which were previously often off-balance-sheet.

Does FASB ASC 842 apply to all leases?

FASB ASC 842 generally applies to leases with a lease term greater than 12 months. Short-term leases (12 months or less) can elect an accounting policy exception, allowing them to remain off-balance sheet and be expensed on a straight-line basis. Certain types of leases, such as those for intangible assets, are also out of scope¹.

How does FASB ASC 842 affect financial ratios?

By bringing significant lease liabilities onto the balance sheet, FASB ASC 842 can increase a company's reported debt, potentially impacting financial ratios like the debt-to-equity ratio, current ratio, and leverage ratios. This can affect how analysts and lenders perceive a company's financial health.

Is lessor accounting different under FASB ASC 842?

For lessors, the accounting under FASB ASC 842 is largely similar to the previous standard, FASB ASC 840. Lessors continue to classify leases as operating leases, sales-type leases, or direct financing leases, depending on whether the lease transfers control of the underlying asset to the lessee.

What is a "right-of-use" (ROU) asset?

A right-of-use asset is a new asset recognized on the balance sheet under FASB ASC 842. It represents a lessee's right to use an identified asset for the lease term and is measured based on the lease liability, adjusted for certain items like initial direct costs and lease incentives.