August 20, 2024
ASC 842 is the recently implemented Accounting Standard for Leases which was needed to be adopted by privately held companies (with December year-ends) effective January 1, 2022. Many have gone through the process of adopting the standard. However, at the time of implementation, some adopted practical expedients, and therefore will need to consider the lease accounting process for new or renewed leases.
Adopting the ASC 842 lease accounting standard can seem daunting, but with a clear approach, your company can transition smoothly to meet the new requirements. Here’s a practical guide to help you navigate the adoption process:
1. Understand the Scope of ASC 842
ASC 842 requires companies to recognize leases on the balance sheet, which includes both right-of-use (ROU) assets and lease liabilities for most leases. Begin by understanding that all leases, whether for office space, equipment, or vehicles, need to be accounted for under this standard.
2. Identify and Review Existing Leases
Start by gathering all lease agreements your company has, including those for office space, vehicles, and equipment. Make sure you identify:
Lease Contracts: Any formal agreements outlining terms.
Key Terms: Payment schedules, lease term, renewal options, and termination clauses.
3. Evaluate Your Lease Agreements
Determine whether ASC 842 applies to each lease . The standard defines a lease as a contract giving you the right to control the use of an identified asset for a period of time in exchange for consideration. Key elements to check are:
Control Over the Asset: You must have the right to obtain economic benefits and direct the use of the asset.
Lease Term and Payments: Review the length of the lease and the payment structure.
4. Calculate Right-of-Use Assets and Lease Liabilities
Once you’ve identified the leases, calculate the ROU asset and lease liability. Here’s a step-by-step approach:
Determine the Discount Rate: Use the rate implicit in the lease if it is available, or your incremental borrowing rate if not.
Present Value of Lease Payments: Calculate the present value of future lease payments, including fixed payments, variable payments based on an index or rate, and the exercise price of purchase options if likely to be exercised.
Lease Liability Calculation: Add the present value of future payments to determine the lease liability.
ROU Asset Calculation: The ROU asset is the lease liability plus any lease payments made at or before the commencement date, plus initial direct costs, and minus any incentives received.
5. Consider the Short-Term Lease Exemption
Under ASC 842, you have the option to not recognize ROU assets and lease liabilities for short-term leases. A lease qualifies as a short-term lease if it has a lease term of 12 months or less and does not include a purchase option that is likely to be exercised. If you choose this exemption, you can account for these leases on a straight-line expense basis over the lease term.
To do this, list all leases that are similar to this situation into one class, and apply it consistently to all leases within that class. Ensure that you document your election decision and apply this treatment to all qualifying short-term leases.
6. Document Your Process
Maintain thorough documentation of your lease calculations, assumptions used, and accounting decisions. This documentation will be essential for audits and future reference.
7. Create a Reconciliation Workpaper for Monthly Closing
Establish a reconciliation workpaper for monthly financial closings to ensure the accuracy of lease accounting entries. This workpaper should:
Compare ROU Assets and Lease Liabilities: Reconcile the amounts recorded on the balance sheet against the calculated amounts from your lease agreements.
Track Amortization and Interest Expense: Verify that the amortization of ROU assets and interest expense on lease liabilities are calculated correctly and recorded in your financial statements.
Adjust for Changes: Include entries for any adjustments due to lease modifications, terminations, or renewals.
Document Variances: Record and explain any variances between your expected and actual lease-related amounts.
Conclusion
Adopting ASC 842 doesn’t have to be overwhelming. By understanding the scope of the standard, reviewing your lease agreements, calculating the necessary amounts, and setting up your systems, you can meet the new requirements effectively. Feel free to reach out to TOPC for support in adopting ASC 842 and preparing or updating your lease accounting workpapers.
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