Lease Accounting

What is ASC 840?

Overview

ASC 840 is the current lease accounting standard governing companies that file under US Generally Accepted Accounting Principles (US GAAP). ASC 842 will replace ASC 840 for public companies on the first fiscal year beginning after December 15, 2019. Private companies will follow one year later.

Why it is Being Replaced

ASC 840 classifies leases as either capital or operating leases. Capital leases are capitalized on the balance sheet and reported on the income statement as an interest and depreciation expense. However, operating leases are reported in the footnotes of financial statements, rather than capitalized on the balance sheet.

After the accounting scandals of the early 2000s, the Securities and Exchange Commission (SEC) believed that this method of reporting operating leases decreased transparency into the true financial position of companies. As a result, it is difficult for smaller investors with limited resources to accurately value companies.

To close the loophole, the SEC directed The Financial Accounting Standards Board (FASB) to develop a new lease accounting standard. The new standard, ASC 842, still classifies leases into two groups: operating leases and finance leases. Finance leases are substantially the same as capital leases under ASC 840. However, companies must report all leases longer than 12 months in length on the balance sheet. The income statement accounting treatment for the two types of leases does not substantially change from ASC 840.

Classification Test

A lease that meets any of the following tests is classified as a capital lease under ASC 840:

  • The underlying asset transfers ownership to the lessee at the end of term
  • There is an option to purchase the underlying asset that is likely to be exercised
  • The lease term is for at least 75% of the remaining economic life of the asset
  • The present value of lease payments plus any guaranteed residual value is at least 90% of the fair market value of the asset