Lease Accounting Standard Has Been Dramatically Revised

Lease Accounting Standard Has Been Dramatically Revised In Recent Year

Lease accounting standard has been dramatically revised in recent years. The entities that play a role of a lessee have seen their price decline, mainly due to the recently effective FASB ASC 842. Read Chap 15 Lease-Accounting Rules May Have Hurt Companies’ Valuations, Study Says - WSJ.pdf from WSJ and answer the following questions: What authoritative requirements made “a recent change in how companies are expected to account for and report operating leases on company balance sheets”? What are operating leases? How are they shown on corporate balance sheets? Describe measuring an amount to be included on the balance sheet and the accounts that are affected. Consider your answer to the question above. How is it possible that accounting prior to the new lease accounting standard might not show leases on the balance sheet?

Paper For Above instruction

The recent overhaul of lease accounting standards, notably through the implementation of FASB ASC 842, has significantly altered how companies recognize and report leasing transactions on their financial statements. Prior to these changes, many leasing arrangements—particularly operating leases—were omitted from the balance sheet, leading to potentially misleading representations of a company's assets and liabilities. This paper explores the authoritative requirements that prompted this transformation, defines operating leases, discusses their presentation on financial statements, and analyzes how accounting treatments have evolved to ensure greater transparency.

The authoritative requirements initiating the recent change stem primarily from the Financial Accounting Standards Board (FASB) issuing ASC 842, which mandates that lessees recognize most leases as lease liabilities with corresponding right-of-use (ROU) assets on the balance sheet. Under the previous standard, ASC 840, operating leases were kept off-balance-sheet, with lease expenses recognized on a straight-line basis over the lease term, but without capitalizing the leased asset or liability. The change aims to improve comparability and transparency, enabling stakeholders to better assess a company's true financial position.

Operating leases are defined as lease arrangements that do not transfer substantially all the risks and rewards of ownership of an underlying asset to the lessee. Typically, these leases are for shorter durations and involve minimal ownership transfer, yet provide the lessee the right to use the asset during the lease term. Examples include rental of office space or equipment. Under ASC 842, these leases are now capitalized, requiring companies to record a lease liability reflecting the present value of future lease payments and an associated right-of-use asset, which represents the lessee's control over the leased asset during the lease period.

The measurement process involves discounting the expected lease payments to their present value using the lessee’s incremental borrowing rate or the rate implicit in the lease, if readily determinable. The resulting lease liability is recognized on the balance sheet, along with a corresponding right-of-use asset. This asset is amortized over the lease term, and interest expense is recognized on the lease liability, impacting income statements over time. A variety of accounts are affected by this recognition, including lease liabilities under liabilities and right-of-use assets under assets, as well as depreciation expenses and interest expenses.

Prior to the adoption of ASC 842, the accounting treatment allowed companies to keep operating leases off the balance sheet, which could mask the extent of their liabilities. The key reason this was feasible was the classification criteria. Operating leases did not transfer ownership nor met the criteria for capitalization, so companies were not required to record them as liabilities or corresponding assets. This approach resulted in inflated asset values and understated liabilities, making companies appear more financially robust than they might actually be. The shift to recognizing lease liabilities ensures a more comprehensive and faithful representation of a company's financial obligations, aligning accounting practices with the economic reality of leasing arrangements.

In conclusion, the revision of lease accounting under ASC 842 enhances transparency by requiring lessees to recognize most leases on their balance sheets. This change addresses previous gaps where operating leases were off-balance-sheet, thus improving the quality of financial information available to investors, regulators, and other stakeholders. While this shift may have impacted company valuations, particularly in sectors reliant on leasing assets, it ultimately fosters a more accurate depiction of corporate financial health.

References

1. Financial Accounting Standards Board (FASB). (2016). ASC 842 Leases.
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