How Will FASB ASC 842 Affect Lease Accounting and Your Business?
The Financial Accounting Standards Board (“FASB”) have begun implementing the new accounting rules for leases this year.
At the high level, FASB Accounting Standards Codification (“ASC”) 842 reduces some of the financial advantages of leasing by placing operating leases on the balance sheet and modifying how companies account for rentals. However, before diving into the technical aspects of lease accounting, let’s make sure we cover the basics.
What is a lease?
In a lease, one party obtains the right to use an asset legally owned by another party for a period of time.
Under the FASB model, a lease was classified based on whether the arrangement effectively purchases an asset. If a lease transfers the control of the underlying asset to a lessee, e.g. equipment has no value at the end of term or lessee can purchase equipment at a nominal value at end of term, then it will be classified as a finance lease.
Otherwise, where a lessee obtains control only of the use of an asset for a limited duration and the equipment retains value at the end of the lease term, the lease will be classified as an operating lease.
How will FASB ASC 842 affect accounting methodology?
For lessors, accounting methodology remains largely unchanged. For lessees, there are significant differences.
Historically, operating leases were not placed on the balance sheet. This provided value to lessees who were motivated by financial engineering or those who sought to mitigate expenses on their books. In addition, the new FASB rules have also changed the methodology for depreciating rentals. Previously, rentals were expensed in a straight-line depreciation. Now, rentals will be considered a depreciating asset called a “Rights to Use,” which is an asset that Lessees do not own, but must place on their books.
When will ASC 842 go into effect?
ASC 842 went into effect for the annual period beginning December 15, 2018 and the calendar year 2019 for public entities. For other entities, ASC 842 went into effect for the annual period of December 15, 2019 and the calendar year 2020. Public entities that present three years of income statements and cash flows must prepare the balance-sheet effect of the adoption of ASC 842 as of January 1, 2017.
What are the effects of the ASC 842?
Experts believe that the new standard will have a material balance sheet impact on about 80% of companies. In addition, the new rule will have a substantial financial impact on public companies. It will add millions of dollars in liabilities, in some cases billions, to corporate balance sheets.
What must your business do to implement ASC 842?
Successful implementation of ASC 842 requires considerable time, resources, and expertise. All things that most businesses lack – especially when it relates to non-core business activities. Many companies appear to be dragging their heels when implementing the new standard.
According to a Q4 2018 study conducted by PwC, only 4% of public company respondents had completed their ASC 842 implementations with 91% of respondents stating that they had not yet completed or started the assessment.
The main challenges to implementation include the consolidation and population of lease data, data analysis, and enhancing or changing systems, processes, or controls. Furthermore, due to the complexity of the new lease accounting rules, most companies must upgrade or modify their existing accounting system or implement new systems to handle the accounting requirements.
Here are a few steps to consider for your company:
1. Review all equipment lease and rental contracts
2. Identify technology requirements
3. Review debt covenants
4. Seek out expertise and counsel
5. Enact a plan and execute
What is the impact of ASC 842 on the future of equipment leasing?
The good news is that the future remains bright. A majority of U.S. business finance their equipment acquisitions and will be able to do so under ASC 842 for the following reasons:
- Tax Management – Leasing allows lessees to manage taxes, by allowing lessors to pass benefits through lower rates.
- Financing – Lessees are still able finance the entire cost of equipment, software, and services without a down payment.
- Cash flow management – Lessors are still able to create smaller, flexible arrangements while the equipment generates revenue.
- Hedge against inflation – Leases allow lessees to lock rates to avoid future inflation.