The Difference Between ASC 840 & ASC 842
ASC 840 is being replaced by ASC 842 as the new lease accounting guidance. Public companies have already adopted the standard for annual reporting periods beginning after December 15, 2018. Private companies originally had an additional year to adopt ASC 842, but in October 2019 the FASB approved an additional year for private companies to comply.
The biggest change from ASC 840 to ASC 842 is the requirement to record an asset and liability associated with all leases greater than 12 months in tenor. Previously, only capital leases were recorded on the balance sheet as an asset and liability. Now, operating leases will also be recorded on the balance sheet as well as the footnotes.
There are a number of other changes that receive far less attention that include:
|Change||ASC 840||ASC 842|
|Lease Recorded Date||Execution Date||Commencement Date|
|Lease Payments Valued||Minimum Lease Payments||Lease Payments|
|Rate and FV Adjustment||Discount Rate adjusted to FV|
Rate implicit in the lease or Incremental Borrowing Rate; No adjustment to FV
|Subleases||Offset the head lease||Treated as two contracts|
There are a few other differences related to capital leases that are highlighted in our Lease Accounting article.
Transitioning from ASC 840 to ASC 842
Operating leases have proliferated over the years for accounting reasons as well as the desire to reduce maintenance expenses. Companies began leasing office equipment from printers, computers, and even plants and furniture. Many companies including those with sophisticated contract administration functions have struggled with capturing all of their leases. Capturing a complete universe of leases and assessing contracts for lease classification has proven to be time consuming and resource intensive. Once leases have been captured in some form of database, companies should capture the relevant terms including maturity, location, currency, underlying asset, and expected payments inclusive of extension options and price inflators. This will allow a company to appropriately estimate the Incremental Borrowing Rate with consideration for the term and economic environment to record the present value of lease payments as the liability with an offset as a right of use asset.
Lease Classification under ASC 842 has changed for both capital leases now referred to as finance leases. We describe the now 5 tests for a finance lease in our lease accounting article. The additional test being that if the underlying asset is so specialized that there is no market for the asset, then it would qualify as a finance lease. Embedded leases are also a new concern under ASC 842 because as part of having to record the present value of operating leases, companies have to determine if they have embedded leases in other contracts. The criteria for determining whether you have an embedded lease in a contract is 1) does the contract implicitly or explicitly specify the underlying asset and 2) does the contract allow for control of the asset. Outsourced manufacturing, services that include devices, and data center contracts are examples of contracts that might have embedded leases.
About the Author
Chandu Chilakapati is a Managing Director at Alvarez & Marsal. He is Head of Innovation for Valuation Services and has 20 years of experience providing fair value solutions. He is a frequent speaker at National Accounting and Valuation Conferences. Mr. Chilakapati is the national lead for complex financial instrument valuation at Alvarez & Marsal.