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December 19, 2019

What is ASC 840?

ASC 840 was the original lease accounting standard as set by the United States Generally Accepted Accounting Principles, otherwise known as GAAP. These accounting guidelines provided different directions for capital and operating leases which created some discrepancies in reporting. Capital leases were noted on the balance sheet while operating leases were oftentimes included in footnotes. 

So what does ASC 842 replace? The Federal Accounting Standards Board, commonly known as FASB, decided to replace ASC 840 with ASC 842. The goal is that this change would provide greater transparency and clarity into a company’s accounting liabilities.

The Difference Between ASC 840 & ASC 842

Does ASC 842 replace ASC 840? Yes, 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.

What is the difference between ASC 840 and 842? 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. View the FASB resources for an in-depth ASC 842 summary of changes:

There are a number of other changes that receive far less attention. An ASC 842 summary of overlooked updates can be found below:

ChangeASC 840ASC 842
Lease Recorded DateExecution DateCommencement Date
Lease Payments ValuedMinimum Lease PaymentsLease Payments
Rate and FV AdjustmentDiscount Rate adjusted to FV

Rate implicit in the lease or Incremental Borrowing Rate; No adjustment to FV

SubleasesOffset the head leaseTreated 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

Accurate ASC 842 examples will take into account a number of factors. 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 for ASC 842 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.

How is lease classification determined under ASC840 vs ASC 842?

ASC 840 required lease classification (determining if a lease is capital or operating) at the time of inception or when the lease was created. Now under ASC 842, this is determined in a slightly different way at the time of commencement or when the lease technically begins. 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.

Executory Costs

These costs tend to include things such as insurance fees, taxes, and maintenance expenses. Previously, ASC 840 required that these be excluded from lease accounting. However, the new ASC 842 standards divides these costs into those related and unrelated to leases. Each company must make a differentiation between these two types of expenses and how they relate to the actual leasing of the asset or property. Those that fall under the umbrella of the lease are included on the balance sheet while the rest are not.

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.

Sources:

FASB Financial Accounting Series, Accounting Standards Update, July 2018


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