Why Lease Accounting Implementation Isn’t Over Yet

by Jennifer Booth

Public companies have been operating under lease accounting standard ASC 842 for a few years now, while most private companies adopted this year. Regardless of the timing of an entity's transition to the new lease accounting guidance, ongoing compliance challenges remain.

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ASC 842 was developed in an effort to provide greater comparability between the balance sheets of companies, regardless of the financing approach they selected.   Though the new standard gives a clearer picture of companies’ lease portfolios, points of confusion can arise during the complex implementation process.  

No matter what part of the implementation journey you’re at, it’s critical to ensure your company doesn’t fall victim to compliance misunderstandings. We’re counting down the five most common myths in lease accounting today: 

Myth #5: “All leases are recorded the same way.” 

Under ASC 842, almost all leases must be accounted for on the balance sheet, but the lease classification impacts the accounting treatment. It’s important to understand the differentiating criteria between the two types of leases: operating leases and finance leases (previously called capital leases).  

There are five criteria to identify a finance lease:  

  • Transfer of ownership occurs by the end of the lease term. 
  • There is an option for the lessee to purchase the asset, and the lessee is reasonably certain to exercise their right to do so. 
  • The period of the lease is a significant part of the asset’s useful life. 
  • The present value of lease payments is the same as or greater than the fair value of the asset.  
  • The asset is so specialized that the lessee has no alternative use for it after the lease ends. 

Even with these straightforward criteria, judgment is often involved in qualifying what is considered “reasonably certain” and a “significant part,” adding another layer of difficulty to the distinction process.  

Meeting any one of these five elements is enough to deem that lease a finance lease. If none of these criteria are met, it should be classified as an operating lease on your company’s balance sheet. 

The determination of whether a lease is classified as operating or capital will drive the expense treatment of the lease.  Operating leases are recognized with a “straight line” expense treatment that is consistent over the term of the lease.  Whereas the finance leases use the effective interest method which results in higher interest expense in the earlier periods of the lease.  Therefore, even two leases of the same asset might result in different economic conclusions based on the terms of the arrangement, if one is classified as operating and the other as financing. 

Myth #4: “We rented this piece of equipment, so there’s no lease.”  

Many companies have equipment leases they aren’t monitoring because they believe if they rented the equipment, it isn’t considered a lease agreement. As a real-world example, one fast food company kept a lease tucked away in a file drawer because they thought they were renting the equipment and that it didn’t need to be tracked. 

Though “renting” and “leasing” are deceptively similar terms, they have distinctions that are critical to understand for reporting purposes. Under ASC 842, a lease is defined as a right to control the use of an asset for a period.  Regardless of the title of the agreement, if your organization obtains the right to direct the use of an asset, then you likely have a lease.  Lease arrangements can run the gamut from forklifts to dishwashers in a ghost restaurant facility, to leased technology devices to assist with order delivery. Even if you think you know what a lease is and what is not, the line is often blurred, so it is critical to abide by ASC 842’s technical definition. 

Myth #3: “Service contracts don’t contain leases.”  

Embedded leases may be “hidden” in service contracts. Embedded leases are sections within contracts that may not even contain the word lease – but that does not mean they don’t need to be accounted for.  These represent assets that are leased by the company as included within a larger contract for services.  Common embedded leases include copier equipment, cable services and IT servers – all of which must be recorded on the balance sheet. 

Myth #2: “A month-to-month lease is different.”  

As you’re compiling your lease portfolio, it’s crucial to understand how specific dates will affect your lease accounting. Short-term leases do not need to be included on the balance sheet. However, a lease must meet these classifications to be considered short-term: 

  • The lease must have a term of 12 months or less at commencement. 
  • There cannot be an ability to extend the lease past 12 months which the lessee is reasonably certain to exercise. 
  • The ability to purchase may exist if the lessee is reasonably certain not to exercise. 

So, even a lease that appears to be “month-to-month” might not meet this definition of a short-term lease. That’s why it’s important to consider all dates involved in a lease agreement to determine whether it should be on the balance sheet.  For example, a company may have a “month-to-month” lease on its delivery vehicles, but if it needs the vehicles to efficiently run its business, then the Company will need to estimate the estimated term of its lease, which will likely be longer than one month, and for much of its fleet, will likely be even longer than twelve months. 

The #1 myth when it comes to leases is...: “Our company implemented ASC 842, so we’re all done with lease accounting challenges.”  

Many companies have experienced historically high levels of lease modifications and terminations since the pandemic as companies are right sizing their business or entering into new business models.  Accounting for modifications and terminations are some of the most complex areas of lease accounting.  This is an area where a good lease software solution can be especially helpful because, with the company’s assistance to complete on-screen prompts about recent activity, the software can generate the appropriate accounting journal entries and reports. 

These five myths reveal that ASC 842 adoption is not over.  

A recent webinar, “ASC 842: The Road to Compliance”, revealed that nearly 25% of participants had not yet begun adopting the standard, showing that the implementation process is still underway for many.   

These myths highlight that ASC 842 is not a “one-time” effort.  Companies must ensure that they have implemented appropriate controls to identify and account for changes in their lease arrangements and that they have appropriate expertise to timely and accurately account for them.  

Jennifer Booth is the Vice President, Accounting at LeaseQuery