As with any accounting standard shift, the new lease standard (ASC 842) brings momentous changes to accounting processes and financial reporting. While the main differences are well-known, I’ve taken a particular interest in the smaller nuances that live within the new standard. (Yes, I’m an accounting nerd and I love learning about and discussing all things related to leases!)
In this article, I’m sharing five of those intricacies that you may not know about the new lease standard, but that are critical to making the transition.
1. Equity likely isn’t impacted
Here is the correct process to follow when transitioning leases from ASC 840 to ASC 842:
- Calculate your lease liability, which is the present value of all future lease payments after the initial application date.
- Remove existing lease balances, such as deferred rent. As you reverse these balances off the books, they should flow through the right-of-use asset, not through the equity balance as is common when implementing a new accounting standard.
- In most cases, the ROU asset is the lease liability, plus or minus the difference of those existing balances.
Note: As with most rules, there are exceptions depending on policy elections and other scenarios. Find those exceptions, along with common missteps to avoid when creating initial journal entries, in here. this article.
2. Watch out for embedded leases
In order to qualify as a lease, the asset must be:
- A physical asset;
- Controlled by the lessee, meaning the organization has the right to substantially all the economic benefits and the right to direct the use of that asset during the contract term; and,
- Explicitly identified in the contract and the supplier does not have the practical ability or economic incentive to substitute out the asset
One example to consider is a service provider that does regular deliveries for your company. They have a fleet of vehicles, but one truck dedicated solely to making your deliveries. The truck is a physical asset and you receive substantially all the economic benefits of it, so it satisfies the first two conditions to qualify as a lease. However, if the supplier could easily substitute that truck, perhaps for a vehicle with better gas mileage, then the asset is not explicitly identified, and thus not an embedded lease.