The Financial Accounting Standards Board (FASB) introduced Accounting Standards Codification (ASC) 842 to transform how companies account for leases. The new standard significantly alters the balance sheets of many organizations by requiring the recognition of most leases as right-of-use assets and related liabilities. While the fundamentals of lease accounting remain rooted in allocating resources and liabilities appropriately, ASC 842 reshapes those fundamentals by bringing more transparency to the operating and financing activities surrounding leases. In this article, we will delve deeply into ASC 842, focusing on the concept of what constitutes a lease and how to determine whether a contract contains a lease. We will explore key components, real-life implications, and the practical steps companies should take to identify and classify leases correctly.
A Brief History of Lease Accounting
Before diving into the specifics of ASC 842, it’s important to understand the context from which the new standard evolved. Prior to ASC 842, U.S. GAAP governed leases primarily through ASC 840, which classified leases as either operating or capital (now referred to as finance). The old standard allowed many operating leases to remain off-balance sheet, resulting in underreported liabilities. For stakeholders looking to assess a company’s true financial position, this created a distorted picture. As businesses grew more dependent on leased assets—from retail stores and offices to equipment and vehicles—analysts, regulators, and other stakeholders pushed for more transparency. The FASB responded by developing ASC 842, which requires lessees to recognize nearly all leases on their balance sheets. This shift aimed to align U.S. GAAP more closely with International Financial Reporting Standards (IFRS 16) and to enable investors and other external parties to better evaluate companies’ financial commitments.
What is a Lease Under ASC 842?
At its core, a lease is a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Under ASC 842, determining whether a contract is, or contains, a lease hinges on two key criteria:
- There must be an identified asset.
- The customer (lessee) must have the right to control the use of that identified asset.
- The identified asset can be explicitly or implicitly specified in the contract. For example, if a manufacturer enters into an agreement to use a particular piece of equipment on the supplier’s premises, and the contract stipulates that this specific piece of equipment will be used, the manufacturer may have the right to control the use of that equipment—provided no substantive substitution rights exist on the supplier’s end. Control, for accounting purposes under ASC 842, means two primary things:
- • The customer has the right to substantially all the economic benefits from the use of the asset.
- • The customer has the right to direct the use of the asset.
- If both of these conditions are met, then the contract contains a lease under ASC 842.
Identifying a Lease: Key Elements
While the formal definition is relatively straightforward, real-world contracts can be complex. Some agreements may not explicitly state that a “lease” exists, yet they still contain the right to use a specified asset. Therefore, identifying a lease involves a careful look at the terms and conditions laid out in any agreement with a third party.
- Identified Asset:
- Is the asset specified in the contract or implied through context?
- Does the supplier have substantive rights to replace the asset with a different one? If so, the asset may not be considered “identified,” because the supplier can swap it out.
- Right to Control:
- Does the lessee obtain all or substantially all of the economic benefits from using the asset? This can include consuming the output or benefiting from changes in the asset’s value.
- Does the lessee have the right to direct how and for what purpose the asset is used?
- Consideration Exchanged:
- What is the payment structure between the parties?
- Is there a fixed or variable payment over a specified term?
- Understanding these elements helps determine whether a contract should be accounted for under ASC 842. This, in turn, affects whether a right-of-use asset and corresponding lease liability should appear on the balance sheet.
Real-Life Facts and Statistics
Implementing ASC 842 has had tangible effects on companies and their financial statements. Here are some notable real-world findings:
• According to a 2020 Deloitte survey, 75% of companies reported that implementing the new lease accounting standard was more complex than initially anticipated.
• A PwC study estimated that over $2 trillion worth of operating leases moved onto U.S. corporate balance sheets upon adoption of ASC 842, underscoring the vast scope of the change.
• Companies in the retail, logistics, and manufacturing sectors were among those with the greatest increases in reported liabilities because of long-term real estate and equipment leases.
These statistics highlight the broad impact of ASC 842 leases on corporate finance and the importance of accurately identifying and accounting for all leases.
Scope Exceptions and Special Considerations
Not all leases fall squarely under the ASC 842 guidance. The standard outlines specific exceptions and nuances that require extra attention:
• Short-Term Leases: If a lease has a term of 12 months or less and does not contain a purchase option that the lessee is reasonably certain to exercise, the lessee can make an accounting policy election not to recognize a right-of-use asset or related lease liability. Instead, lease payments can be recorded as expenses on a straight-line basis, similar to the older approach under ASC 840.
• Embedded Leases: Some service contracts or other agreements may have an embedded lease. For instance, a service agreement to manage IT servers might provide the customer with the right to use specific servers in a designated space, effectively creating a lease within the contract. Companies must identify these hidden leases and account for them appropriately to remain in compliance with ASC 842.
• Variable Lease Payments: While fixed lease payments are straightforward, variable payments can complicate calculations. Payments based on usage or performance criteria may need careful allocation. ASC 842 typically requires lessees to include certain variable payments in the right-of-use asset and lease liability, especially those tied to an index or rate.
• Sublease Transactions: When a lessee becomes a lessor by subleasing the asset to another party, additional assessment is required to ensure that both the head lease and the sublease are accounted for properly. The classification of the sublease as operating or finance can differ from that of the head lease.
Practical Tips: Evaluating a Contract for a Lease
When confronted with a new or existing contract, finance and accounting professionals should undertake a systematic approach to determine whether the contract is or contains a lease. While the details can vary by industry or transaction structure, a step-by-step checklist can help streamline the evaluation process.
- Identify the Asset
- Assess Control Rights
- Determine Economic Benefits
- Examine Substitution Rights
- Review Payment Structure
- Document Findings and Conclusion
- Each of these steps requires careful reading of the contract terms, discussions with operational teams, and sometimes direct communication with the counterparty to clarify ambiguous clauses. Proper documentation of each step will not only support your conclusion but also simplify audits or future reviews of lease agreements.
Embedded List: Common Pitfalls in ASC 842 Lease Identification
A major challenge for companies lies in recognizing all leases, especially those hidden within larger contracts. Some of the most common pitfalls include:
• Failing to Recognize Embedded Leases: Overlooking smaller components of larger service agreements.
• Misinterpreting Substitution Rights: Not all substitution rights negate an identified asset; they must be substantive.
• Inadequate Internal Controls: Without consistent processes for review, lease identification often falls through the cracks.
• Underestimating Variable Payments: Ignoring or oversimplifying payment structures tied to usage, performance, or indices.
Avoiding these pitfalls requires a robust internal mechanism to flag and evaluate all relevant agreements. Training procurement, legal, and operational staff can go a long way in ensuring that any contract with potential lease elements is flagged for further accounting analysis.
Beyond Identification: Classification and Disclosure Requirements
Once you determine that a contract is, in fact, a lease, the next crucial steps involve classification and disclosure:
• Classification as Operating or Finance Lease: Under ASC 842, the distinction between operating and finance leases depends on several factors, including ownership transfer and the present value of payments compared to the fair value of the asset. While both types of leases now appear on the balance sheet, classification affects how a company recognizes interest and amortization expenses.
• Disclosure: ASC 842 expands disclosure requirements, seeking greater transparency in financial statements. Lessees must disclose qualitative and quantitative information about their leases, including maturity analyses, variable lease expenses, and options related to extension or termination.
• Transition Methods: Companies transitioning to ASC 842 from ASC 840 had different paths, including the modified retrospective approach or the prospective approach. While most companies have already implemented ASC 842, the transition choices made in prior periods continue to affect current reporting and comparability.
Real-World Impact: Putting ASC 842 into Practice
The magnitude of leased assets in many industries means the practical effects of ASC 842 are significant.
• Balance Sheet Transparency: Organizations that relied heavily on leases now show larger asset and liability balances. While this can make financial metrics like return on assets appear weaker, it provides a more accurate picture of the company’s obligations.
• Lease vs. Buy Decisions: With the off-balance sheet benefit largely gone for operating leases, some companies have started re-evaluating whether leasing remains the best option. In many cases, the operational flexibility of leases still outweighs the drawbacks, but the conversation has become more nuanced.
• System and Process Overhauls: Implementing ASC 842 has often required companies to upgrade or replace their lease management systems. This not only helps identify leases but also automates ongoing calculations and reporting. For many businesses, the initial investment in software and training is balanced against the risk of non-compliance and the inefficiencies of manual processes.
Conclusion
ASC 842 marks one of the most significant changes in recent accounting history, forcing companies to reconsider how they categorize and report leases. By requiring that almost all leases go on the balance sheet, FASB has effectively shined a spotlight on financial obligations that were previously hidden in footnotes or off-balance sheet entirely. To comply with ASC 842, companies must carefully scrutinize every contract for the presence of an identified asset and the right to control that asset. This process involves understanding substitution rights, variable payments, and the nuances of embedded leases. Once a contract is deemed a lease, classification as operating or finance and robust disclosures about terms, maturity, and variable elements become crucial. The real-world data underscores the magnitude of this accounting shift: trillions of dollars added to balance sheets, and a heightened awareness among stakeholders of the capital and operational costs tied to leases. Far from being a purely technical issue, ASC 842 shapes a company’s strategic decision-making around leasing versus purchasing and demands stronger internal controls to monitor leasing activity. Ultimately, ASC 842’s primary aim is greater transparency. By shedding light on a company’s lease obligations, stakeholders from investors to lenders gain deeper insights into a firm’s financial health. For companies, rigorous lease identification and classification processes, plus ongoing vigilance, are essential to ensure compliance and to maintain the trust of their shareholders and the broader financial community.
