Under new accounting standards set by FASB, Financial Accounting Standards Board, ASC 842 required a more in-depth balance sheet for leases to increase transparency for companies that report under GAAP. These changes went into effect in 2019 and changed how the business’s balance sheet was viewed by ensuring that all leased assets and liabilities are capitalized instead of only being disclosed in the footnotes. It’s imperative for your business’s finances to be up to date with the latest standards for management and owners to make the best decisions for the company.
With outdated accounting standards for leases, ASC 840, assets and liabilities from the leases were not included on the balance sheet and were merely discussed in the footnotes. FASB estimates that $3 trillion dollars were not being reported appropriately. Now, assets (also labeled a right of use asset) and liabilities are recorded properly giving any reader of their financial statements a clear view on all leasing activities. This enables readers of the financial statements to have a more concise idea of the company’s amount, timing, and uncertainty of cash flow from leases, and for the readers to have a better comprehensive, detailed report in the statement disclosure. This also helps show the risks involved with leases.
Operating Versus Finance Leases
Under ASC 842, leases are labeled as an operating or finance lease depending on the terms of the contract for the lease.
Finance Leases
Leases are labeled finance leases if there is evidence of ownership in the contract under one of the following arrangements:
- The asset’s title transferred to the lessee at the end of the contract.
- A purchase option is offered to the lessee at the end of the contract.
- 75% of the assets useful life is utilized during the term of the contract.
- 90% of the fair market value is paid from the total of payments through the contract.
With the finance lease, there are two separate expenses – interest and depreciation. The depreciation expense on the asset is included as a part of the EBIT, earnings before interest and taxes, however, the interest expense on the lease liability is included in the EBIT.
Operating Leases
Unlike a finance lease, the two expenses (depreciation and interest) are added together and listed as a single lease expense and are included with the EBIT. This expense will be consistent throughout the term of the contract and equal to the amount of rent payments.
Example for Accounting for Lessees
A lawn mower company leases a truck. The contract is paid annually for two years in the amount of $572 with a 10% interest rate.
Under a Finance Lease
The interest and the depreciation are separately listed over the next two years. The present value is capitalized calculated at $992.73 using Excel formula PV=(rate,nper,payment).
The journal entry to record the asset and liability:
Dr. Leased Asset $992.73
Cr. Leased Liability $992.73
The debt amortization table:
| Year | Payment | Interest | Principle Adjustment | Principle Balance |
| 10% | $992.73 | |||
| 20X7 | $572 | $99.27 | $472.73 | $520 |
| 20X8 | $572 | $52 | $520 | $0 |
The journal entry for the first payment:
Dr. Interest Expense $99.27
Dr. Lease Liability $472.73
Cr. Cash $572
Using straight line depreciation, the simplest method, the depreciation is $496.37. This is labeled as the “Amortization Expense.” The journal entry for the depreciation will be:
Dr. Depreciation expense $496.37
Cr. Accumulated Depreciation $496.37
The total amortization expense is as follows:
| Depreciation | Interest | Total | |
| 20X7 |
$496.37 |
$99.27 |
$595.64 |
| 20X8 |
$496.36 |
$52.00 |
$548.36 |
| Totals |
$992.73 |
$151.27 |
$1,144.00 |
Under an Operating Lease
With an operating lease, the lessee will capitalize on the operating expense at the time of origin. The lessee will also only recognize one expense instead of two (depreciation and interest added together), and the expense will equal the amount of the lease payment.
The journal entry to record the asset and liability:
Dr. Leased Asset $992.73
Cr. Lease Liability $992.73
The expenses for the first year will be listed as follows:
Dr. Lease Expense $99.27 (Interest)
Dr. Lease Liability $472.73
Cr. Cash $572.00
Dr. Lease Expense $496.37 (Depreciation)
Cr. Accumulated Depreciation $496.37
The expenses for the second year will be listed as follows:
Dr. Lease Expense $52 (Interest)
Dr. Lease Liability $520
Cr. Cash $572
Dr. Lease Expense $496.37 (Depreciation)
Cr. Accumulated Depreciation $496.37
The total amortization expense is as follows:
| Depreciation | Interest | Total | |
| 20X7 |
$472.73 |
$99.27 |
$572.00 |
| 20X8 |
$520.00 |
$52.00 |
$572.00 |
| Totals |
$992.73 |
$151.27 |
$1,144.00 |
Notice that when the company is contracted through a finance lease, the expenses in the first year are higher than in the operating lease ($595.64 versus $575). Also, the expenses are separated in the finance lease, and, in the operating lease, the total is included in the EBIT. With these included but separated from the other assets and liabilities, readers are able to gather information concerning the business’s activities and relationships. Leases carry rights and risks differently than owned assets, so it’s imperative to have the full view of the business’s current contracts.
From the Lessor’s Perspective
Assets and liabilities are listed separately as they are from the lessee’s perspective. They are also further classified as current or noncurrent. However, different than the previous, profits and losses are recognized at the commencement date of the lease and labeled as either gross or net based on the lessor’s business model.
Disclosure Statements
While the lease’s values are inputted into the balance statement, additional information concerning the lease is still put into the disclosure footnotes. This enables a reader to take into account every factor and possible consequence. Information includes:
- Information about the lease – general description, terms and conditions, options for the lease to be extended or the asset to be purchased
- Information about assumptions and judgements – whether or not the contract contains a lease, amounts derived from the lease, any discount rates included
- Information on how the risks associated with the lease are going to be managed
- Information concerning any future leases that have not yet commenced
Quantitative information concerning the profit/loss and costs associated
- Any related party’s transactions
- Policy elections and expedients
- Sale and leaseback transactions
ASC 842
With these new financial standards, more work is put into each statement, but more value is brought to the table with increased transparency concerning each business and the possible risks they are facing with leasing contracts. This allows possible business relationships and the business’s owners to truly grasp any measures that may need to be taken. By understanding ASC 842, Kislay Shah CPA helps to control the recognition and disclosure of leases allotting for financial transparency for his clients and their investors. Feel free to contact Shah at kislay@shahcpaus.com or call 646-328-1326.