ASC 842 is a new lease accounting standard issued by the Financial Accounting Standards Board (FASB) that became effective for public companies on December 15, 2018, and for private companies on December 15, 2019. This standard replaced the previous lease accounting standard, ASC 840.
Under ASC 842, all leases with a term of more than 12 months must be recorded on a company's balance sheet as a right-of-use (ROU) asset and a corresponding lease liability. This applies to both lessees and lessors. The ROU asset represents the lessee's right to use the underlying asset, while the lease liability represents the lessee's obligation to make lease payments over the lease term.
To determine the lease liability and ROU asset, a lessee must calculate the present value of the lease payments using the lessee's incremental borrowing rate (IBR), which is the rate of interest the lessee would have to pay to borrow money to purchase the leased asset. The lease liability is the present value of the lease payments. At the same time, the ROU asset is equal to the lease liability plus any initial direct costs incurred by the lessee and any prepaid or accrued lease payments.
The lease liability and ROU asset must be reevaluated and adjusted throughout the lease term to account for any changes in the lease payments or lease term. The lease liability is reduced as lease payments are made, and the ROU asset is depreciated over the lease term. The depreciation expense is recognized in the income statement, while the interest expense on the lease liability is recognized separately.
ASC 842 also requires additional disclosures in a company's financial statements, including information about the nature of its lease arrangements, the timing and amount of lease payments, and the significant assumptions and judgments made in determining the lease liability and ROU asset.
The new lease accounting standard represents a significant change in how companies account for their leases. It accurately represents a company's financial position by including all leases on the balance sheet. It also makes it easier for investors and analysts to compare companies, as all leases are accounted for consistently. Companies must ensure they have the necessary systems and processes to comply with the new standard and should work with their auditors and advisors to ensure a smooth transition.