ASC 842 is one of the most significant changes in accounting to come about recently, next to ASC 606. It replaced ASC 840 as the core accounting standard on leases. Fundamentally, ASC 842 requires that all leases are recorded on the balance sheet. The objective of ASC 842 is to increase transparency and comparability among entities by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. Previously, many leases were off-balance sheet and not a faithful representation of the rights and obligations arising from leases. This article focuses on the ongoing recognition and measurement of leases under ASC 842, and not the transition date considerations.

Scope

A lease is a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. The following assets are not within the scope of leases:

• Leases of intangible assets (e.g., licensing arrangements)
• Leases of assets under construction (e.g., construction work-in-progress)
• Lease of inventory
• Leases to explore for or use minerals, oil, natural gas, and similar nonregenerative resources
• Leases of biological assets

Key Concepts

1. Determine whether an arrangement contains a lease

At the inception of the lease, the entity should assess whether a contract is, or contains a lease, by applying the following three criteria:

• Is there an identified asset?
• Does the entity have the right to obtain substantially all of the economic benefits from the use of the PP&E?
• Does the entity have the right to direct the use of the PP&E?

If any one of the criteria above are not met, then the contract is not, or does not contain a lease.

2. Classification

Lessee

A lessee will classify the lease as a finance lease if any of the following criteria at lease commencement:

• The lease transfers ownership to the lessee at the end of the lease term.
• The lease contains an option to purchase the property that the lessee is reasonably certain to exercise.
• The lease term is for the major part of the remaining economic life of the property.
• The present value of the lease payments and any residual value guaranteed is equal to or exceeds substantially all of the fair market value of the leased property.

If none of the above criteria is met, then the lease will be classified as an operating lease.

Lessor

A lessor will classify the lease as one of the following:

• Sales-type lease: If any of the lease classification criteria for lessees are met, the entity will classify the lease as a sales-type lease.
• Direct financing lease: If none of the lease classification criteria for lessees are met, the entity will classify the lease as a direct financing lease when both of the following criteria are met:
  • The present value of the sum of lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all the fair value of the underlying asset.
  • It is probable that the entity will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.
• Operating lease: If the lease is not a sales-type or direct financing lease, the lease will be classified as an operating lease.

3. Determine the components of a lease

Once the entity has identified that a contract is a lease, the entity should identify the non-lease components and the non-components within the contract.

• Non-lease component: an activity that transfers a separate good or service to the customer is a non-lease component. (e.g., common area maintenance, utilities, etc.).
• Non-component: any activity in a contract that does not transfer a separate good or service to the lessee is neither a lease component nor a non-lease component (e.g., property taxes or insurance).

The lease consideration (e.g., lease payment) should then be allocated between the lease and non-lease components based on their relative standalone prices unless the entity has elected the practical expedient to not separate lease and non-lease components. The consideration in the contract would not be allocated to non-components.

4. Determine the lease commencement date

The lease commencement date is the date on which a supplier makes the asset subject to the lease available for use by the lessee. This will be the date used to record the initial recognition and measurement of a lease for the entity. In addition, the lease classification is also determined on the lease commencement date.

5. Determine the lease term

The lease term is defined as the noncancellable period (e.g., period that contains enforceable rights and obligations in the contract) for which a lessee has the right to use an underlying asset, and includes the following:

• Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option.
• Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.
• Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.

6. Determine the discount rate

Lessees

At lease commencement, a lessee must develop a discount rate to calculate the present value of the lease payments so that it can determine lease classification and measure the lease liability. When determining the discount rate to be used at lease commencement, a lessee must use the rate implicit in the lease unless that rate cannot be readily determined. When the rate implicit in the lease cannot be readily determined, the lessee should use its incremental borrowing rate. The incremental borrowing rate is the rate of interest that 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.

Lessors

For a lessor, the discount rate for the lease is the rate implicit in the lease. The rate implicit in the lease cannot be less than zero. The rate implicit in the lease can be backed into by setting the PV of lease payments and PV of the amount the lessor expects to derive from the underlying asset to the FV of the underlying asset and any deferred IDCs.

7. Determine the lease payments

Lease payments include fixed payments, variable lease payments based on an index or rate, the exercise price of a purchase option that is reasonably certain of being exercised, penalties for terminating lease early, and residual value guarantees. These payments are calculated at the commencement of the lease and will be used to determine the appropriate lease classification and measure the ROU and lease liability. Lease payments do not include variable lease payments that do not depend on an index or rate, amounts allocated to non-lease components, or asset retirement obligations.

Recognition and Measurement Model

Lessees

Initial Recognition

At the commencement date of the lease, the lessee will recognize a ROU asset and lease liability in its books. The initial recognition of the ROU asset and lease liability is the same for operating leases and finance leases. Lessees can make an accounting policy election to not apply ASC 842 to short-term leases, which are defined as leases that have a lease term of 12 months or less at commencement date.

• Lease Liability- The lease liability is equal to the present value of the lease payments, discounted using the rate implicit in the lease (or if that rate cannot be readily determined, the lessee’s incremental borrowing rate).
• ROU Asset- The ROU asset is measured at an amount equal to the lease liability, adjusted for prepaid/accrued rent, unamortized initial direct costs and lease incentives.

Subsequent Recognition

The lease liability for an operating lease at any given time is calculated as the present value of the remaining lease payments not yet paid, discounted by using the rate that was established on the lease commencement date.

The lessee measures the ROU asset at any given time as the amount of the lease liability, adjusted for the following:

• Cumulative prepaid or accrued lease payments
• Remaining balance of any lease incentives received
• Unamortized initial direct costs
• Impairment of the ROU asset

For operating leases, the entity will recognize expense on a straight-line basis over the lease term by adding interest expense determined using the effective interest method to the amortization of the ROU asset. The lease expense is presented as a single line item in operating expense in the income statement and tested for impairment.

For finance leases, the entity will recognize the following in expense:

• Amortization of the ROU asset over the shorter of the useful life of the asset or the lease term
• Interest on the lease liability using the effective interest method
• Variable lease payments that are not included in the lease liability
• Changes to variable lease payments that depend on an index or rate
• Any impairment of the ROU asset

Lessors

Initial Recognition assuming collectability is probable

1. Sales-type leases

• Recognize a net investment in the lease (i.e., the sum of the lease receivable and the present value of the unguaranteed residual value.)
• Derecognize the carrying value of the underlying asset.
• If the fair value of the underlying asset equals the carrying value, defer any IDCs.
• Recognize any selling profit or selling loss immediately.
• If the fair value of the underlying asset does not equal the carrying value, expense any IDCs immediately.

2. Direct financing leases

• Recognize a net investment in the lease (i.e., the sum of the lease receivable and the present value of the unguaranteed residual value.
• Defer the IDCs and selling profit within the net investment in the lease.
• Derecognize the carrying value of the underlying asset.
• Recognize any selling loss immediately.
• Do not recognize any selling profit at commencement.

3. Operating leases

• Defer IDC.
• If lease payments are received up front, recognize consideration received as a deposit liability.
• The carrying value of the underlying asset will still be reflected as fixed asset.
• No income statement impact at commencement of the lease.

Subsequent Recognition

1. Sales-type leases

• Reduce the net investment in the lease for consideration received from the lessee.
• Increase the net investment in the lease for interest income earned.
• Reduce the carrying value of the net investment in the lease due to any impairment
• Recognize interest income on the basis of the net investment in the lease at the implicit rate in the lease.
• Recognize income from variable lease payments that are not included in the net investment in the lease.
• Recognize changes to variable lease payments that depend on an index or rate in profit or loss in the period of the change.
• Recognize any impairments.

2. Direct financing leases

• Reduce the net investment in the lease for consideration received from the lessee.
• Increase the net investment in the lease for interest income earned.
• Reduce the carrying value of the net investment in the lease due to any impairment.
• Recognize interest income on the basis of the net investment in the lease at the implicit rate in the lease.
• Recognize changes to variable lease payments that depend on an index or rate in profit or loss in the period of the change.
• Recognize any impairments.

3. Operating leases

• Recognize any deferred rent receivable/deposit liability.
• Reduce capitalized IDCs for amortization
• Recognize lease income over the lease term on a straight-line basis unless another systematic and rational basis better represents the pattern in which benefit is expected to be derived.
• Recognize changes to variable lease payments that depend on an index or rate in profit or loss in the period of the change.
• Amortize any IDCs.
• Depreciate the underlying asset.

Sublease arrangements

For any sublease arrangements in which the entity acts as both lessee and sub-lessor for the same underlying asset, the entity accounts for the head lease and sublease as separate contracts. See below for the additional considerations of the sublease accounting:

• The sublease is subject to lessor accounting guidance.
• If the total remaining lease cost on the head lease for the term of the sublease is more than the anticipated sublease income for that same period, this may be an impairment indicator of the ROU asset recognized in the head lease.
• The entity should assess whether it is relieved from its primary obligation under the head lease. If the entity is not relieved from head lease, the entity should continue to account for head lease in one of the following ways depending on the classification:
  • If the sublease is classified as an operating lease, the original lessee shall continue to account for the original lease as it did before commencement of the sublease.
  • If the original lease is classified as a finance lease and the sublease is classified as a sales-type lease or a direct financing lease, the original lessee shall derecognize the original ROU asset and continue to account for the original lease liability as it did before commencement of the sublease.
  • If the original lease is classified as an operating lease and the sublease is classified as a sales-type lease or a direct financing lease, the original lessee shall derecognize the original ROU asset. The original lessee shall evaluate its investment in the sublease for impairment.

Modification and Remeasurement

Depending on the facts and circumstances, a lease modification may be accounted for by the lessee and lessor as either:

1. two leases: the original lease and a separate new lease, or
2. one modified lease.

If the lease modification is not accounted for as a separate lease, the lessee shall reallocate the remaining consideration in the contract and remeasure the lease liability using a discount rate for the lease determined at the effective date of the modification. A lessor would remeasure and reallocate the remaining consideration in the contract, reassess the classification of the lease at the effective date of the modification and account for any initial direct costs, lease incentives and other payments made to or by the lessor.

The following table summarizes the accounting by modification type for lessees: 

A lessee is required to remeasure its lease liability and adjust the related ROU asset upon the occurrence of the following:

• A triggering event that changes the certainty of a lessee exercising an option to renew or terminate the lease, or purchase the underlying asset
• A change to the amount probable of being owed by the lessee under a residual value guarantee
• The resolution of a contingency upon which variable lease payments are based such that that those payments become fixed

A termination of a lease before the expiration of the lease term will be accounted for by the lessee by derecognizing the ROU asset and the lease liability, with the difference recognized in profit or loss. The lessee’s purchase of the underlying asset is not considered a lease termination under ASC 842. When a lessee purchases the underlying asset, it would reclassify the ROU asset balance and adjust the carrying value of the purchased asset by the difference between the purchase price of the asset and the lease liability immediately before the purchase.