Last Updated on March 1, 2024 by Morgan Beard
ASC 840 was the original accounting standard for leases that allowed companies to disclose their leases in the notes of their financial statements. Operating leases under ASC 840 were not shown in the financial statements. In February 2016, FASB issued a new leasing standard, ASC 842, to replace ASC 840 and provide more consistency and transparency.
For your company, the transition may already be complete or still underway. But for now, it’s important to understand the former standard ASC 840 well, so the transition is smooth and efficient, and you can clearly recognize the former method and understand the differences.
Let’s start with answering what ASC 840 is, and then we’ll get into the classification, recognition, and measurement of leases under this standard, outlining what’s included and what’s not. We’ll also give an overview of the impact of modifications in ASC 840.
What is ASC 840?
ASC 840 is the former lease accounting standard for public and private companies that follow US GAAP. Leases were classified as either capital or operating, differing in how they were recorded on the company’s financial statements.
What classifies as a lease under ASC 840?
A lease is a contract that outlines the right to use an underlying asset for a period of time in exchange for payment. To determine whether an agreement contains a lease, it is important to assess both:
- Whether there is an identified asset involved
- Whether the contract allows the right to control the use of the asset in exchange for payment for some time
It’s also important to note that ASC 840 applied to contracts for the right to use land and/or depreciable assets. Therefore, specific arrangements were outside the scope of the ASC 840, including:
- Leases of inventory or construction in progress
- Leases of intangible assets, including licensing agreements for software, plays, and manuscripts.
- Lease agreements to explore or use natural resources
- Leases of biological assets
ASC 840 Lease Classification
The lease classification — capital or operating — should be determined at the lease commencement date. This classification impacts the lease’s recognition, measurement, disclosure and other financial reporting.
Under ASC 840, the lease classification was determined by the following criteria:
- Ownership transfer
- Bargain purchase option
- Lease term
- Present value of minimum lease payments
Only if the lease was modified or an option was exercised should a reassessment of lease classification be required under ASC 840.
What are Capital Leases Under ASC 840?
A capital lease is treated like an asset and a liability on the balance sheet which means the asset depreciated and incurred interest over time.
To be considered a capital lease under ASC 840, one of the following criteria must be met.
- Indication of the transfer of ownership
- Bargain purchase option
- Lease term greater than or equal to 75% of the useful life of the asset
- Present value of minimum lease payments greater than or equal to 90% of the fair value of the leased property
If one of the criteria is met, the journal entry would be:
Debit: Right-of-use asset
Credit: Lease liability
Each payment would decrease the lease liability and record interest, using the effective interest method as an expense. Amortization is recorded on the right-of-use asset on a straight-line basis.
Direct Financing vs. Sales-Type Lease
US GAAP further classifies capital leases as either a sales-type lease or a direct-financing lease. The difference is an upfront profit, which would classify the lease as a sales-type lease.
A direct financing lease is treated as a loan, typically producing declining revenue similar to interest over the lease term. The investment includes the present value of minimum lease payments and the asset’s residual value. Income falls relative to declining investment and matches the pattern of interest-carrying costs. The manufacturer or dealer records a sale and the related cost of sales at the beginning of the lease.
The title needs to automatically transfer to the lessee at the end of the term to be classified as a sales lease for real estate. This type of lease converts the property carried at wholesale cost to the regular selling price. Subsequent accounting is the same as accounting for a direct financing lease.
What Constitutes an Operating Lease Under ASC 840?
An operating lease is a contract that allows the use of an asset without transferring the ownership right for any less than the majority of the asset’s life unless the lessee pays virtually all of the asset’s fair value.
Under ASC 840, if none of the above criteria is met, the lease is considered an operating lease.
The journal entry is as simple as:
Debit: rent expense
ASC 840 Lease Recognition and Measurement
Classification and measurement of the leases are to be determined at inception, but recognition of rent expense or capital lease assets and liabilities begins at the commencement of the lease.
Capital leases are recorded on the balance sheet, and interest and depreciation expenses are measured.
Operating leases do not impact the balance sheet and are allowed to be disclosed in the notes of a financial statement.
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ASC 840 Lease Payments
Minimum lease payments are payments that a lessee must make regarding the leased asset and are recorded at the commencement of the lease.
Incremental direct costs
The lease payments calculation includes incremental direct costs, such as legal fees, even if they were incurred before the lease started, and residual value guarantees but excludes executory costs and contingent rents.
Executory costs are costs that are incurred with owning and operating the property, such as insurance, taxes, and maintenance, and are excluded from all lease calculations. An estimate of these costs to be excluded from the minimum lease payments is required if they are included in rental payments.
Contingent rent is not fixed or agreed upon in advance, but the amount paid depends on some future event, such as an increase or decrease in sales or an increase or decrease in the use of the asset. They are excluded from minimum lease payments and accounted for as an expense or income in the period they were incurred or earned.
Penalties for canceling the lease
The purchase price is included in lease payments if it is reasonably sure that the lessee will purchase the leased asset. But if it is reasonably certain that the lessee will not terminate a lease, the lease termination penalty is excluded from lease payments.
Residual value guarantees
When calculating the capitalized lease liability, the entire amount of any residual value guarantees is included in the minimum lease payments. The residual value means the estimated fair value of the leased property once the lease term comes to an end.
Land fair value
When the fair value of the land is 25% or more of the combined fair value of the land and building, the land should be classified separately.
Under ASC 840, the implicit rate in the lease or the company’s incremental borrowing rate is used. The incremental borrowing rate is the rate that would have been incurred to borrow over a similar term to purchase the leased asset. This discount rate is used to calculate the current value of lease payments when determining the lease classification.
It is important to note that a lessee can not record a capital lease asset on the financial statements greater than the asset’s fair value. Therefore the discount rate must be increased to a rate that will reduce the asset and the liability until it is equal.
How are Lease Incentives Accounted for under ASC 840?
Lease incentives are a common way to encourage a new lessee to enter a new lease contract. Lease incentives could be things like covering moving expenses and a reduced rent rate.
Under ASC 840, lease incentives are accounted for as a separate liability which is reduced on a straight-line basis.
ASC 840 Lease Modifications
You would first determine which changes constituted a lease modification or a termination of the lease contract.
Changes in a lease other than to extend or renew the lease are analyzed using two tests. Lease renewals and extensions are considered new leases.
The first test is used to determine whether the lease classification used at inception would have been different if the change was in place and all other factors remained the same. If this test changes the lease classification, then the lease is reflected as a new lease and moved on with the second test.
The second test is calculated at the date of changed lease terms using revised lease terms to determine the required accounting for the new lease.
Moving forward with ASC 842
Now, ASC 842 is replacing ASC 840 so that all lease liabilities should be accounted for on the balance sheet, among other changes. This allows for transparency into an organization’s lease obligations and financial position.
All companies should have transitioned to ASC 842 by now, as public companies were given a transition date deadline of January 1, 2019, and private companies had an extension until January 1, 2022, for December 31, 2021, year-ends.
Let Occupier help
Although ASC 840 was the legacy standard for lease accounting, and we have since evolved to ASC 842, it’s essential to understand the nuances of both standards and the key differences as you transition your accounting practices.
If you need help with lease accounting, check out our “Ultimate Guide to Lease Accounting” or set up a demo with Occupier to see how we can help. Occupier creates a more efficient process for your leases by enabling real estate and accounting teams to seamlessly manage their lease portfolio and comply with accounting standards.
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