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 qualifies as a lease under ASC 840?

Under ASC 840, a lease is a contract that conveys the right to use an identified asset for a period of time in exchange for payment, covering land and depreciable assets but excluding inventory, intangible assets, natural resources, and biological assets. 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 

How were leases classified under ASC 840?

Under ASC 840, leases were classified as either capital or operating at the lease commencement date based on four criteria: ownership transfer, bargain purchase option, lease term relative to asset life, and present value of minimum lease payments relative to fair value. 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 and how are they accounted for?

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.

What is the difference between a direct financing lease and a sales-type lease under ASC 840?

The key difference is the presence of an upfront profit. A sales-type lease generates a profit at inception and requires the manufacturer or dealer to record a sale and cost of sales at the start of the lease. A direct financing lease is treated like a loan, with declining revenue recognized over the lease term.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?

Under ASC 840, a lease is classified as an operating lease when none of the four capital lease criteria are met. Operating leases do not appear on the balance sheet and are expensed as rent on a straight-line basis.

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

Credit: cash

How were leases recognized and measured under ASC 840?

Under ASC 840, lease classification and measurement were determined at inception, with capital leases recorded on the balance sheet and operating leases disclosed only in the notes to the financial statements.

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.

What lease payments were included in minimum lease payment calculations under ASC 840?

Minimum lease payments under ASC 840 included incremental direct costs, residual value guarantees, and purchase prices when ownership transfer was reasonably certain, but excluded executory costs and contingent rents.

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

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 rents

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. 

Discount rates

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 were lease incentives accounted for under ASC 840?

Under ASC 840, lease incentives were recorded as a separate liability and reduced on a straight-line basis over the lease term, distinct from the treatment under ASC 842 where incentives reduce the ROU asset directly. 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.

How were lease modifications handled under ASC 840?

Under ASC 840, lease modifications were analyzed using a two-step test to determine whether the change altered the original lease classification and whether the modification should be treated as a new lease.

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.

What do finance teams need to know about moving from ASC 840 to ASC 842?

ASC 842 requires all operating leases to be recognized on the balance sheet, which is the most significant departure from ASC 840. Public companies transitioned by January 1, 2019, and private companies by January 1, 2022. 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.

How does lease management software help with ASC 840 to ASC 842 transition knowledge?

Understanding both ASC 840 and ASC 842 is essential for finance teams managing leases that originated under the old standard, particularly when auditors review transition adjustments or prior period comparatives.

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.