For many years, accountants and financial professionals from both private and public companies have used ASC 840 as the standard approach for leases. Things changed dramatically with ASC 842 coming into effect and replacing ASC 840.
This article will compare ASC 840 vs ASC 842, with a specific focus on ensuring the smoothest way to move an entire lease portfolio to ASC 842, the new lease standard.
ASC 840 – What is It?
ASC 840 was the primary standard for dealing with leases. To understand the implications of ASC 842 replacing ASC 840, it is important to review ASC 840, the previous lease accounting standard.
ASC 840 mandated two types of lease classification, namely operating leases and capital leases. Capital leases were represented through balance sheet lease accounting, while operating leases were expensed through the income statement.
This classification depended on the following issues:
- If the ownership of the underlying asset transferred to the lessee at the end of the term
- If there is an asset purchase option that is likely to be exercised
- If the lease term is for at least 75% of the remaining economic life of the asset
- If the present value of lease payments (plus any guaranteed residual) is equal to 90% of the fair market value of the underlying asset
Critically, the disclosure around such leases was minimal, sometimes only requiring a footnote in the financial statements – a loophole, also known as “off-balance sheet” elements, that was used in various accounting scandals.
This is the context in which the FASB launched its new standard or Topic, ASC 842. ASC 842 seeks to bring all leases onto the balance sheet, and thus close the existing loophole.
Difference between ASC 840 and ASC 842
There are several critical and fundamental differences between ASC 840 and ASC 842.
Definition of a lease
It doesn’t get more fundamental than this. ASC 842 effectively updates the definition of a lease, which has tremendous knock-on effects.
One of these is the subject of embedded leases – contracts that do not explicitly contain a lease, but where the circumstances of the agreement meet the lease definition per ASC 842.
ASC 842 defines a lease as a “contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”
The critical term here is “control”: which is defined as
- The right to obtain substantially all of the economic benefits from the use of the identified asset
- The right to direct the use of the identified asset
Under ASC 840, an arrangement could contain a lease even without “control.” This new lease definition is arguably the biggest difference between the old and new accounting standards.
Leases reflected on the balance sheet
While ASC 840 allowed for operating lease transactions to be expensed through the income statement, ASC 842 mandates the creation of a right-of-use asset and a lease liability on the balance sheet.
Specifically, ASC 842 requires that “A lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term.”
ASC 842 includes details around lease modifications – what constitutes a lease modification and how to deal with such modifications. Items that potentially result in a lease modification according to ASC 842 are:
- changing the consideration
- extending or shortening the lease term
- leasing additional or less space than what was originally agreed in the lease
Once a potential lease modification has taken place, the key question is: is this a change to the existing lease, or a separate lease?
The 2 tests are:
Has this modification granted an additional right of use asset to the lessee that was not included in the original lease?
Have the lease payments increased in line with the value of a standalone asset of this type?
If the answer to both of these questions is affirmative, a separate lease should be accounted for.
Inception vs Commencement
ASC 840 dictated that lease classification – that is, whether the lease is an operating lease or capital lease – should be done at inception.
ASC 842 on the other hand, highlights lease commencement as the critical date.
ASC 842 has very specific disclosure requirements, which are in many ways more detailed than what was required under ASC 840.
ASC 842 requires companies to provide both qualitative and quantitative information about:
- Its leases, including a general description to provide more information to users
- The significant judgments made in applying the requirements of ASC 842 to these leases
- The amounts recognized in the financial statements relating to these leases
Dealing with direct costs
While ASC 840 allowed certain direct costs to be capitalized, including many of those incurred before the execution of the lease, ASC 842 prohibits many of these initial costs, or incremental costs of a lease, from being capitalized.
ASC 840 vs 842: ensuring smooth ASC 842 compliance
Just as people were getting used to ASC 840, ASC 842 introduced with new definitions, new accounting treatments, and new ways of doing things.
Part of the challenge of ASC 842 is the added complexity of keeping track of lease agreements, managing all leases across the organization, and the additional burden that sometimes small changes have on the leasing function as a whole.
This is one of the reasons that having lease accounting software in place is so critical. With Trullion’s lease accounting software, for example, you get seamless compliance with ASC 842, without the headache of manually trying to keep up.
Automate your lease processes, reduce time spent on maintaining your accounting for leases, and ensure accuracy and compliance. Let AI-enhanced technology do the heavy lifting for you!
Interested in learning more? Get in touch or request a demo.