The Financial Accounting Standards Board (FASB) 842, also known as the new lease accounting standard, was introduced in 2016 and took effect for public companies in 2019. The standard aims to improve financial reporting and transparency by requiring companies to provide more detailed information about their leasing activities. This paper will explore the key provisions of FASB 842 and its impact on financial reporting.
Background
Before the introduction of FASB 842, companies were allowed to report their lease obligations as operating leases. This meant that companies could keep lease liabilities off their balance sheets and disclose only minimal information about their leasing activities in the footnotes of their financial statements. This practice made it difficult for investors and analysts to accurately assess a company's financial position and obligations.
FASB 842 requires companies to recognize all leases on their balance sheets as assets and liabilities. This means that companies must disclose the present value of their future lease payments as liabilities and record a corresponding right-of-use asset on their balance sheets. This change is intended to improve transparency and provide stakeholders with a clearer view of a company's leasing activities and obligations.
Key Provisions of FASB 842
Identification of a lease - Under FASB 842, a lease is defined as a contract that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. This means that companies must identify and account for all leases, including those embedded in service contracts and other agreements.
Lease classification - FASB 842 requires companies to classify their leases as either finance leases or operating leases. Finance leases are leases in which the lessee assumes substantially all of the risks and rewards of ownership, while operating leases are leases in which the lessor retains most of the risks and rewards of ownership.
Lease measurement - Companies must measure their lease liabilities as the present value of their future lease payments. The lease liability is recorded on the balance sheet as a noncurrent liability, while the corresponding right-of-use asset is recorded as a noncurrent asset.
Lease expense recognition - Under FASB 842, companies must recognize their lease expenses on a straight-line basis over the term of the lease. This means that the total lease expense will be recognized evenly over the life of the lease, rather than being front-loaded or back-loaded.
Disclosures - FASB 842 requires companies to disclose information about their leasing activities, including the nature and terms of their leases, the amount and timing of their lease payments, and the significant assumptions used to determine their lease liabilities and right-of-use assets.
Impact of FASB 842 on Financial Reporting
FASB 842 has significant implications for financial reporting, particularly for companies with significant leasing activities. The new standard requires companies to provide more detailed information about their leasing activities, which will improve transparency and enable stakeholders to make better-informed decisions.
The requirement to recognize all leases on the balance sheet will have a significant impact on a company's financial statements. Companies will see an increase in both assets and liabilities on their balance sheets, which could affect key financial ratios such as debt-to-equity and return on assets.
The new standard may also have an impact on companies' debt covenants and borrowing capacity. The increase in liabilities on the balance sheet could affect a company's debt-to-equity ratio, which is often used as a key measure of a company's creditworthiness. This could lead to higher borrowing costs or restrictions on borrowing capacity.
FASB 842 will also have a significant impact on companies' accounting processes and systems. Companies will need to implement new processes and systems to identify and account for all leases, as well as to calculate the present value of their future lease payments.