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As finance and accounting departments manage challenges such as limited resources and an increased volume of data, they also must navigate a new lease accounting standard called the Accounting Standard Codification 842 (ASC 842), which updates the definition of a lease and requires businesses to report operating leases on their financial statements.
The Financial Accounting Standards Board (FASB) created the standard in 2016, with the goal of correcting the perceived problem of lessees leaving operating leases off their balance sheets. Analysts and investors argued that companies with operating lease payments each month appeared less indebted than companies with mortgages for office space or other kinds of financing arrangements to report on their balance sheets.
Notably, the FASB announced public companies had to comply with the standard for fiscal years after December 15, 2021. After receiving an extension, private companies must comply with ASC 842 by their first annual report of 2022 – which, for most calendar-year companies, was December 31, 2022.
The need for private companies to comply with ASC 842 requirements continues to be daunting for some. However, private companies moving toward compliance or refining their reporting processes for the future can keep track of their leases with updated lease accounting software that is tailored to comply with the ASC 842 standard.
How is ASC 842 compliance challenging, and how can companies adapt?
Prior to ASC 842, lessees could leave certain leases off their balance sheets if they passed the “bright line” test. This test required specific lease term lengths and minimum lease payments based on the asset’s economic life and fair value in order for the lease on that asset to be included on a balance sheet. Now, accountants must track down all leases that previously went unreported due to the bright line test.
The first step to complying with ASC 842 is to pin down and include agreements that now count as leases under the new standard. With the exception of certain short-term leases, both “operating leases” and “finance leases” must be reported. The new lease accounting standard defines a lease as an operating lease when the lessee does not control the underlying asset and as a finance lease when a lessee does control the underlying asset.
The new rule also introduces several new terms that accounting departments must adopt when tackling their lease accounting, such as “right-of-use (ROU) asset” and a “lease liability.” ROU assets are those that will be capitalized by the lessee and represent the lessee’s right to use an underlying asset for the lease term. Rather than label the asset as a capital asset – such as a truck – the ROU description will enable financial statement users to separate those assets actually owned from those capitalized because of leases.
Although the new standard includes some changes that affect lessor accounting and disclosure, such as eliminating leveraged leases, the new rule mostly affects lessees.
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