A guide to ASC 842
Navigating the new lease accounting standard, ASC 842, established by the Financial Accounting Standards Board (FASB), can be a bit daunting. Accurately identifying whether a contract contains a lease is crucial for proper financial reporting and compliance. ASC 842 has expanded lease accounting, requiring organizations to recognize most leases on their balance sheets.
Understanding the Lease Definition under ASC 842
Before diving into whether a contract contains a lease, it's essential to grasp the definition of a lease under ASC 842. A lease is a contract, or part of a contract, that provides the right to control the use of an identified asset for a specific period in exchange for consideration.
The Two-Step Approach: Identifying a Lease within a Contract
ASC 842 simplifies lease identification in a contract with a two-step approach:
Step 1: Pinpointing an Identified Asset
An identified asset is explicitly or implicitly specified in the contract. To qualify as an identified asset, it must meet the following criteria:
- The asset is physically distinct (e.g., a particular floor in a building, a specific vehicle, or a unique piece of equipment).
- The asset is separable from other assets (e.g., the lessee has exclusive rights to use the asset without interference from other parties).
If a contract involves using a substantial portion of an asset but doesn't grant exclusive rights, it doesn't contain an identified asset.
Step 2: Evaluating the Right to Control the Use of the Identified Asset
A contract contains a lease if the customer has the right to control the use of the identified asset throughout the period of use. To establish this right, the following conditions must be met:
- The customer has the right to obtain substantially all the economic benefits from using the identified asset during the lease term. This means the customer can benefit from the asset's output, capacity, or other utilities and can restrict others from benefiting from it.
- The customer has the right to direct the use of the identified asset, meaning they can decide how and for what purpose the asset is used. This could include determining when, where, or how much output to generate.
If a contract grants the customer the right to control the use of an identified asset, it's considered a lease under ASC 842.
Determining if a contract contains a lease under ASC 842 is critical in ensuring accurate financial reporting and compliance with the new lease accounting standard. By understanding the lease definition, applying the two-step approach to identify an identified asset and the right to control its use, and recognizing embedded leases within contracts, businesses can confidently navigate the complexities of ASC 842.
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