In February of 2016, the Financial Accounting Standards Board (FASB) released update ASC 842, changing the way we account for leases. The biggest change brought on by this is that businesses are now required to recognize the assets and liabilities arising from all leases on their balance sheet, except certain leases with terms of 12 months or less. Previously, leases were classified as either capital or operating, and only capital leases required recognition of an asset and liability on the balance sheet. This old method of accounting received some criticism for being misleading and not representing the full picture of leasing transactions and the effects that leases can have on the assets and liabilities of a company. Leasing is used as a common means to acquire access to assets for the the benefit of a business, without the full costs or potential legal consequences of buying and owning the same asset. Lease agreements and the assets being leased can be instrumental to the operations of a business. That is why FASB issued update ASC 842, to ensure more comprehensive and complete information for all users of financial statements. Now, the new classifications of financing and operating leases both require recognition on the business’s balance sheet.
Whether it be property, plant, or equipment that is being leased, if you, a lessee, receive the economic benefits from, and direct the use of the asset you are leasing, you are now required to recognize it as a right-of-use asset on your balance sheet. This means you will also amortize this asset over the life of the lease term. Alongside this right-of-use asset, you will recognize a lease liability, representing your obligation to make the lease payments. As mentioned previously, there is one exception – short term leases, defined as leases with a term of 12 months or less. If a lease is short term, you can opt to not recognize it on the balance sheet and expense the lease payments over its life.
Lease Classification: Finance vs Operating
Leases previously were classified as either capital or operating. Now, under ASC 842, any preexisting capital leases will be classified under a new name: finance leases. There are 5 criteria for finance leases, but a lease must meet only one of them to be a finance lease. (Spiceland et al., 2023)
- The terms of the lease specify that ownership of the asset transfers to the lessee
- The lease agreement contains an option to purchase the asset that the lessee is “reasonably certain” to take advantage of
- The term of the lease encompasses most of or all the asset’s remaining useful economic life
- The present value of all lease payments is equal to or more than the fair value of the asset
- The asset is so specialized that at the end of the lease, it would have no alternative use to the lessor
Determining whether a lease is an operating lease is simpler. If your lease does not meet any of the criteria above, it is considered an operating lease. Operating leases are considered more like a rental agreement, as opposed to finance leases, which are more like the purchase of an asset. However, the lessee of an operating lease would still record a right-of-use asset and lease liability. So, what makes an operating lease any different from a finance lease on the financial statements? The main difference is in how the expense is recorded. For an operating lease, you will report one single expense, the lease expense, which represents the rental of the asset over the duration of the lease term. For a finance lease you will record interest expense and amortization expense separately, representing your right to use the asset, and financing the lease agreement. Another difference is that while an operating lease still results in a new liability on the balance sheet, it is designated as a “non-debt liability,” distinguishing it from other liabilities, including finance leases (Spiceland et al., 2023).
The changes brought on by this update became effective for fiscal years beginning after on December 15th, 2018, for all public business entities, nonprofits organizations having issued securities that are traded in a public market, and employee benefit plans that file with the U.S. SEC. For other entities, the update became effective for years beginning after December 15th, 2019.
Companies that have become accustomed to the old way leases were handled may struggle with how to treat them going forward. Having an advisor to help implement the standard can clarify the reasoning behind the change and advise on the potential benefits and liabilities of leasing. They can show how diverse ways to fund an operating asset.
Works Cited
Financial Accounting Standards Board. (2021). Accounting Standards Update No. 2021-05: Leases (Topic 842): Lessors—Certain leases with variable lease payments. FASB.
Spiceland, J. D., Nelson, M., Thomas, W., & Winchel, J. (2023). Intermediate accounting (11th ed.). McGraw-Hill LLC.
