Explain the differences between the accounting treatment for leases under ASC 842 and the previous lease accounting standard, providing specific examples.
The accounting treatment for leases drastically changed with the adoption of ASC 842, which replaced the previous standard, ASC 840. Here's a breakdown of the key differences:
1. Lease Classification:
ASC 840: Distinguishes between "capital leases" and "operating leases." Only capital leases were recognized on the balance sheet.
ASC 842: Introduces a single model where all leases with a term of more than one year are recognized on the balance sheet. Leases are classified as either finance leases or operating leases based on their substance, but both types are treated as on-balance sheet items.
Example:
ASC 840: A company leases a piece of equipment for 5 years, with the lease meeting the criteria for a capital lease. This lease would be recorded on the balance sheet as an asset and a liability. A company leasing an office building for 10 years that did not meet the capital lease criteria would be recorded as an operating lease, only recognized in the income statement.
ASC 842: The same equipment and office building leases would both be recorded on the balance sheet under ASC 842. The equipment lease would be classified as a finance lease, while the office building lease might be an operating lease.
2. Balance Sheet Recognition:
ASC 840: Only capital leases resulted in asset and liability recognition.
ASC 842: Both finance and operating leases require the recognition of a right-of-use (ROU) asset and a lease liability on the balance sheet.
Example:
ASC 840: A company leasing a car for 3 years under a capital lease would record the leased car as an asset and the lease liability on its balance sheet.
ASC 842: The same car lease under ASC 842 would result in the recognition of a ROU asset representing the company's right to use the car and a lease liability representing the company's obligation to make lease payments.
3. Income Statement Impact:
ASC 840: Operating lease payments were expensed over the lease term, while capital leases resulted in depreciation expense and interest expense.
ASC 842: Both finance and operating leases result in depreciation expense (for the ROU asset) and interest expense (on the lease liability). Operating lease payments are split between these two expenses.
Example:
ASC 840: A company with a 5-year operating lease on office space would expense the annual lease payment on the income statement each year. A company with a 5-year capital lease would record depreciation expense for the leased asset and interest expense on the lease liability.
ASC 842: The company with the operating lease on office space would record depreciation expense on the ROU asset and interest expense on the lease liability, with the total expense reflecting the split of the lease payment.
4. Disclosures:
ASC 840: Required limited disclosures about operating leases.
ASC 842: Requires more extensive disclosures, including:
Nature and terms of lease arrangements
Lease payments
Maturities of lease liabilities
Significant judgements and assumptions
Example:
ASC 840: A company might simply disclose the total amount of operating lease payments in its financial statements.
ASC 842: The company would be required to provide much more detailed information, including the breakdown of lease payments, the maturity schedule of lease liabilities, and the impact of the leases on key financial ratios.
In summary, ASC 842 represents a significant change in lease accounting, moving from a limited recognition model to a comprehensive one. This shift leads to greater transparency and comparability of financial reporting across companies.