Article
Important considerations for calculating ASC 842 assets and liabilities
Oct. 26, 2020 · Authored by Calvin Swartley
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Article
Oct. 26, 2020 · Authored by Calvin Swartley
The new leases standard, Accounting Standards Codification (ASC) 842, was released in 2016 and caused organizations to rethink their balance sheets; implementing ASC 842 can make valuing assets and liabilities a complicated process.
The new standard is intended to improve the financial reporting for lease transactions. Leases for property or equipment with terms greater than 12 months are required to be recognized as assets and liabilities on an organization’s balance sheet.
ASC 842 has already been adopted by public companies reporting under U.S. generally accepted accounting principles (GAAP), but the Financial Accounting Standards Board (FASB) originally gave private companies with a calendar year-end until 2021 to implement the standard. The effective date was recently deferred one year for private companies and private not-for-profits to fiscal years beginning after Dec. 15, 2021, and interim periods within fiscal years beginning after Dec. 15, 2022.
All organizations should consider the impact ASC 842 could have on their financial statements as well as the steps and inputs required to adequately record these assets and liabilities.
Under the standard, a lessee will now recognize a lease liability and a right-of-use (ROU) asset for all of their leases. This includes all operating leases with a term greater than 12 months; lessees can make an accounting policy election not to apply the new requirements to short term leases with a term less than 12 months. This will have an immediate impact on balance sheets because it could significantly increase the assets and liabilities listed on an organization’s financial statements. Organizations will have to follow these general procedures for recognizing assets and liabilities relating to leases accounted for under ASC 842.
Initial measurement of assets and liabilities related to leased property is critical for financial statement accuracy and prevention of future impairments which could arise if assets are overstated.
Under the standard, a lessee will now recognize a lease liability and a right-of-use (ROU) asset for all of their leases… This will have an immediate impact on balance sheets because it could significantly increase the assets and liabilities listed on an organization’s financial statements.
On the lease commencement date, a lessee is required to measure and record a lease liability equal to the present value of the remaining lease payments. The liability is then discounted using the rate implicit in the lease, if determinable, or the lessee’s incremental borrowing rate.
ASC 842-10-30-5 outlines the standards for calculating lease payments. Lease payments consist of six primary components:
Once the lease payments have been calculated, they’re discounted based on the rate implicit in the lease, if determinable, or the incremental borrowing rate.
The rate implicit in the lease represents the rate of interest that, at a given date, causes the aggregate present value of the lease payments — and the amount a lessor expects to derive from the underlying asset following the end of the lease term — to equal the sum of the fair value of the underlying asset, minus any:
The incremental borrowing rate is the rate of interest a lessee would have to pay to borrow on a collateralized basis over a similar term — an amount equal to the lease payments in a similar economic environment.
However, ASC 842-20-30-3 provides an alternative for lessees that aren’t public business entities; it allows a lessee to use a risk-free rate for a period comparable to the lease term. The risk-free rate will be inherently lower than an incremental borrowing rate for a specific entity and result in a higher lease liability and ROU asset.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
An organization can decide to use a risk-free rate via an accounting policy election. Once it’s elected, it must be used consistently for all leases.
ASC 842-20-30-5 provides guidance for valuing ROU assets.
ROU assets consist of three components:
Initial direct costs by the lessee include items such as:
Initial direct costs don’t include:
As stated in ASC 842-20-35-9, a lessee’s ROU asset is subject to impairment guidance in ASC 360, and would be subject to the same testing guidelines as long-lived assets. Long-lived assets, or asset groups, will be tested for recoverability whenever events or changes in circumstances indicate its carrying amount may not be recoverable.
Errors do occur in rate selection. Selecting a rate that’s too high or low could lead to understating or overstating the lessee’s liability and related ROU.
A potential example would be selecting an unsecured loan rate that was allowed under ASC 840 but isn’t allowed under ASC 842. Typically, an unsecured borrowing rate will be higher than a secured borrowing rate. Using a rate that’s too high will understate the liability and potentially create misleading financial statements. Adversely, selected a rate that’s too low could overstate the lessee’s ROU and increase the chances for future impairments.
Another potential error when valuing ROUs is including costs that aren’t initial direct costs. Each initial direct cost included in the ROU must be analyzed in detail, so the cost directly relates to the ROU and meets the requirements for a direct cost. Otherwise, the lessee increases their risk of overstating their ROUs and creating larger impairments in the future.
