What does ASC 842 mean in practice if your real estate portfolio consists of finance leases? Well, the first change is in the wording: a capital lease under ASC 840 is now called a finance lease under ASC 842. Along with this name change, there is also additional accounting compliance scope with the new standard, set in motion by the Financial Accounting Standards Board.

In this piece, we’ll define and illustrate some ASC 842 finance lease best practices.

What are Finance Leases Under ASC 842?

A finance lease under ASC 842 transfers ownership of the leased asset to the lessee at the end of the lease term or meets one of five classification criteria, requiring balance sheet recognition of both an ROU asset and a lease liability. At its core, a finance lease transfers ownership of the leased asset to the lessee at the end of the lease term.

There are five main lease classification criteria, which we've detailed in our blog on How to Perform a Lease Classification Test. For our purposes today, the critical difference between accounting for operating leases and accounting for finance leases is that the latter requires both a lease amortization schedule as well as a recorded interest expense. 

Once you have determined if you have a finance lease not operating lease, then you are ready to start calculating your ROU assets and lease liability. If you do have an operating lease, then take a look at our sister post, How to account for operating leases under ASC 842.

How do you account for a finance lease under ASC 842?

Finance lease accounting under ASC 842 requires recording a lease liability and ROU asset at the present value of lease payments, recognizing interest expense separately from ROU asset amortization on the income statement, and classifying principal repayments as financing activities on the cash flow statement. ASC 842 replaces the old obligation under ASC 840 to record capital lease assets and lease obligations. In its place, teams need to record:

• A lease liability, which is the total financial obligation owed by the lessee toward the lessor.
  
• A right-of-use asset, which is a valuation of the period of a lessee’s access to an asset.
  
• Interest expense is the interest accrued on the amount owed to a lessor
  

To record these figures under ASC 842 for a finance lease, teams should follow these steps:

1. In the statement of financial position: Record the right-of-use asset and the lease liability, which are initially measured at the present value of the lease payments.
2. In the statement of comprehensive income: Record the interest on the lease liability separately from the amortization of the right-of-use asset.
3. In the statement of cash flows: Under financing activities, list repayments of the principal portion of the lease liability. Within operating activities, list interest payments on the lease liability and variable lease payments.

The next  step in ASC 842 finance lease accounting is measuring the straight-line expense. This is included in the income statement and helps show a lease’s direct impact on cash flow in each period. You can calculate the straight-line expense with the following equation:

Straight-line expense calculation

In this equation, the total of all lease payments throughout the lease period, in addition to any initial direct costs incurred by the lessee, gets subtracted by any lease incentives offered by the lessor, all divided by the number of periods in the lease term.

How are finance lease modifications accounted for under ASC 842?

A finance lease modification under ASC 842 either results in a new separate lease or triggers remeasurement of the existing lease liability and ROU asset, depending on the nature and scope of the change. Under the new standard, some modifications to a lease will result in a new lease that must be recorded. But in all other cases, changes will trigger a re-measurement of the lease liability and right-of-use asset.

When it comes to recalculating the right-of-use asset and lease liability, some key modifications that can trigger reassessment are changes in the discount rate for future payments, a change in the lease term, or some new incentives or up-front costs placed on the lessee by the lessor.

What are embedded leases and how do you identify them under ASC 842?

An embedded lease within a broader contract when the agreement depends on an identified asset, the customer obtains substantially all of the economic benefits from using that asset, and the customer has the right to direct its use. Three prerequisites must be met in order for a contract to contain an embedded lease:

1. the contract depends on an identified asset
2. the customer has the right to obtain substantially all of the economic life benefits from use of the PP&E
3. the customer has the right to direct the use of the PP&E

The subsequent accounting treatment for embedded leases entails separation of non-lease and lease components. IT contracts are the most common embedded lease examples, combining services like support and the right to use an underlying asset like servers. 

So in this next section we will look at a practical example that applies lessee accounting principles to the underlying asset within an embedded lease of an IT contract. 

What does embedded finance lease accounting look like in practice?

The following example walks through how an IT contract containing a server fleet and support services is separated into lease and non-lease components, with the lease component accounted for as a finance lease. He and his IT team has signed a contract that includes a fleet of servers and support of those servers with the following terms:

• Lease commencement date: August 1, 2022
• Lease Classification: Finance lease
• Lease term: 5 years
• Fair market value of the server fleet: $500,000
• Payments Frequency: Monthly
• Lease Payments: $10,000
• Service Payments: $1,000
• Incremental Borrowing Rate: 7%
• Useful life of the server fleet: 10 years
• At the end of the lease term, John has the purchase option of the fleets for $200,000, which is the asset’s fair market value at the end of the lease term. 

What does a finance lease modification look like in practice?

The following example shows how a change in business circumstances that makes a renewal option reasonably certain to be exercised triggers lease remeasurement, updating both the ROU asset and lease liability balances. Accounting for a lease modification can receive one of two accounting treatments:

1. It is treated as a separate lease
2. It is not treated as a separate lease

In this scenario, our lease modification will not be treated as a separate lease. Many entities will encounter a modification that includes a change due to variable payments like CPI also known as consumer price index or exercise their right to renew, terminate, expand etc.

ACME Inc. entered into a lease agreement on November 1, 2022 to lease a new company van for a term of 23 months. The fixed cost per month was $490. And, the lease has an extension option for a two-year period at the same price. ACME Inc believes they will only need the vehicle for 23 months at this point in time so they do not currently  plan to exercise their right to renew option.

Upon assessment by ACME Inc’s finance team, it was determined that this lease is a finance lease. Initial calculations revealed that this lease will bring a ROU Asset of $11,015.98 and a corresponding lease liability of the same amount.

Two days later on November 3, 2022, ACME Inc., signed a large contract with a new customer. Due to the large new contract ACME Inc. knows that they will now need the leased van for the additional two-year period. 

Given the updated business use case, ACME Inc. now knows they will need the leased vehicle for the additional two-year period. So, they will have to re-assess the lease accounting with respect to the van lease. 

This has triggered what is called a re-measurement due to the fact that the assumptions and judgements made with respect to this lease have changed since the initial accounting was performed.

Modification to the Terms:

On November 3, 2022, ACME Inc. exercised their right to renew their their van lease which resulted in a re-measurement. Upon re-measuring the lease, ACME Inc. noted that an adjustment of $11,048.22 was required to capture the new assumptions and circumstances surrounding the leased van.

What do finance teams need to know about finance lease accounting under ASC 842?

Finance lease accounting under ASC 842 requires mastering lease liability calculations, ROU asset amortization, interest expense recognition, modification accounting, and embedded lease identification across the full lease portfolio. Creating your journal entries will require lease liability, ROU assets, and interest calculations. 

Transitioning to ASC 842 finance lease accounting will be a significant challenge for your business and impact your company's balance sheets. As outlined in the examples, lessee accounting calculations will provide your team better insight into your leasing agreement and financial reporting.

Take a look at our comprehensive lease accounting resource hub to find out about key definitions and calculations under ASC 842 and finance leases. If you have any questions, reach out to our team. Schedule a demo today if you're ready to test drive our lease accounting software.