For many companies, leasing certain assets is cheaper than buying them. It often makes more sense to lease office space, warehouses, factories, computers, cars and other equipment rather than buying them outright. Recently, however, the rules for recording these leases in accounting have changed. As of January 1, 2022, private companies and nonprofit organizations must follow a new rule, ASC 842 for lease accounting.
What is ASC 842 lease accounting?
In 2021, the Financial Accounting Standards Board (FASB) introduced ASC 842 for lease accounting. The goal of ASC 842 is to make financial reporting more transparent by making sure that all leases are shown on a company’s balance sheet. ASC 842 replaces the old accounting standard for leases, ASC 840.
ASC 842 vs ASC 840
Under ASC 840, leases were considered either “operating” or “capital.” Operating leases enabled use of an asset but did not confer any ownership to the leasee. Capital leases, on the other hand, transfer ownership to the leasee after a fixed period of time. Also under the previous standard, lessees recorded assets and liabilities related to the lease if the rental contract met specific requirements. Because operating leases were not entered as assets or liabilities on the balance sheet, however, this sometimes gave an inaccurate view of a company’s financial health and operations.
Under the ASC 842, leases are classified as either operating or finance. Like capital leases, finance leases transfer ownership of the asset to the lessee at the end of the lease term. Also, companies must report all leases of 12 months or more as both assets (known as right-of-use (ROU) assets) and liabilities. ASC 842 also covers leases that are part of service contracts, usage contracts, and other agreements. Companies should carefully review all their contracts to identify and classify every lease. This will provide a clearer picture of their financial commitments.
ASC 842 lease accounting challenges
To successfully adopt ASC 842, organizations will need to collect detailed information about their lease portfolio. For example, they should know each lease’s term, renewal options, lease payments and discount rates.
Not all companies have this data readily available. To meet reporting requirements, they may need to adapt their processes, enhance IT systems and refine their internal controls. Training employees in the new standard and working closely with auditors are also important steps for ensuring compliance.
Organizations that fail to adopt ASC 842 will be out of compliance with U.S. GAAP standards. As a result, they may face significant delays in completion of their audit and risk a qualified audit opinion. ASC 842 could also impact key ratios and affect compliance with loan covenants.
Special considerations for nonprofits
Nonprofit organizations face their own set of challenges in complying with ASC 842. They are more likely to receive donated space or below-market rental agreements. They are also more likely operate with limited accounting resources.
In those cases, a nonprofit must account for lease payments made in accordance with ASC 842. It must also account for the difference between lease payments and the fair market value of the use of the leased asset, recording it as a contribution in accordance with ASC 958.
The difference is treated as nonfinancial assets, which include additional financial statement disclosures in accordance with FASB 2020-07 Not-for-profit Entities (Topic 958): Presentation and Disclosures by Not-For-Profit Entities for Contributed Nonfinancial Assets.
Learn more about ASC 842 lease accounting
ASC 842 represents a significant change in lease accounting. Companies can manage the challenges of ASC 842 and make sure they meet the new rules, however. Steps they can take include careful planning, investing in technology and working with consultants or external accountants. Contact BPM to learn more today.
