Accounting standards are continuously reviewed to modernize accounting guidelines. Governing bodies such as FASB (Financial Accounting Standards Board) gather input from stakeholders, then issue fresh guidance in the Accounting Standards Codification (ASC).
A recent hot topic issue surrounds operating leases. FASB issued a new standard, ASC 842 (Accounting for Operating Leases), that created a lot of conversation about adjusting accounting practices to align with the guidelines.
This article will cover the basics of an operating lease, why a new accounting standard was issued, and a typical operating lease accounting example to illustrate how this change impacts your company.
What is an Operating Lease?
An operating lease is a type of business agreement where an owner (lessor) of an asset gives someone (a lessee) access to a specific asset. The lessee (e.g., your business) can use the asset for a certain amount of time depicted in the lease agreement. While using the operating lease, the lessee continues to make agreed-upon payments to pay off the asset.
Complicating matters is that an operating lease falls under both accounting standards, ASC 840 and ASC 842. The accounting for each of these standards is different.
- ASC 840 (former standard): a capital lease classification.
- ASC 842 (new standard): a finance lease classification.
Regarding choosing which accounting standard to follow, there are a few differences to keep in mind.
ASC 840 vs. ASC 842
Under ASC 840, operating leases were considered off-balance sheet transactions, which means they weren’t processed in a company’s books. The rent expense associated with a lease contract was recognized in the income statement but not in the balance sheet.
This situation made it difficult to truly understand a company’s commitments to lessors. It also made it difficult to compare the financial standing of two distinct companies because they may have used different operational approaches to capital versus leased assets. For these reasons, the ASC 842 standard was created.
ASC 842 increases transparency across all businesses. Now, all leases must be recognized on a business’s balance sheet. Companies must also identify an asset’s right of use and record a corresponding lease liability.
Finance Lease vs. Operating Lease
For a lease to be classified as a finance lease, it must meet one of the five criteria listed below. If it doesn’t meet at least one of the following criteria, it will be identified as an operating lease:
- Purchase Option: does the agreement grant the lessee an option to purchase the asset?
- The present value represents almost all of the fair value of the asset: the present value of the sum of the remaining lease payments must equal or exceed the underlying asset’s fair value.
- Transfer of title/ownership to the lessee: does the agreement include a transfer of ownership of the underlying assets to the lessee by the end of the lease term?
- Asset Specialization: the underlying asset is for a unique purpose and is expected to have no other use for the lessor at the end of the lease.
- Lease term for a major part of the remaining life of the asset: If the lease term covers the majority of the remaining economic life of an asset, it is considered a finance lease.
Lease Capitalization Requirements Under 842
There are exceptions granted under ASC 842, as not all operating leases are required to be capitalized.
The primary category of leases that do not be capitalized is short-term leases. For example, if you enter into an agreement that is 12 months or less with no purchase option, you do not need to record a lease asset or liability on the balance sheet.
Also excluded are low-value assets and leases priced below a certain level. FASB did not define a dollar amount for what they call the “materiality threshold” of what does not need to be recorded on your books. However, entities are encouraged to “adopt reasonable capitalization thresholds below which lease assets and lease liabilities are not recognized.”
Operating Lease Accounting Example from ASC 840 to ASC 842
Aligning with FASB requirements is complicated. Let’s review an operating lease accounting example to better drive home the requirements for a business owner.
Scenario: Suppose you already have an asset in use, such as a high-powered machine. The lease document includes the following stipulations:
- Lease terms for renting the machine.
- The present value of the asset.
- Length of the lease agreement.
- Conditions for returning the asset to the lessor.
- Terms for whether the lessee can assume ownership of the machine upon completion of the lease term.
What You Should Do:
- Determine the lease term under ASC 840.
- Determine total lease payments under GAAP.
- Prepare a straight-line amortization schedule under ASC 840.
- Determine the total amount of payments remaining.
- Adjust how you account for the operating lease to align with ASC 842.
- Calculate and record the operating lease liability.
- Calculate and record the right-of-use asset.
Need Support Accounting for Operating Leases?
Our team of accounting experts understands how to help companies transition to operating under the terms of the new ASC 842 standard.
Finlyte would be glad to review your current operating leases to ensure everything aligns with the new standards. We can also review lease agreements that do not reflect the new standard to bring your company into compliance.
We offer this support as part of our outsourced accounting services. Our goal is to simplify complex accounting situations that growing businesses encounter. Let us provide you with dedicated support.
Do you have an operating lease accounting example in your company that you would like us to review? Contact Finlyte today to schedule a consultation with our team.