Decoding ASC 840: Essential Information for Accountants

Lease accounting has undergone a seismic shift, and the transition from ASC 840 to ASC 842 has left many businesses rethinking their approach to compliance. While ASC 842 brings transparency and balance sheet recognition, understanding ASC 840 remains critical for historical audits, financial comparisons, and seamless adaptation. 

In this essential guide, we are going to explore ASC 840, uncover its complications, and prepare you for a confident leap to the future of lease accounting. Whether you're a seasoned accountant or a business leader, this knowledge is your key to clarity.

What is ASC 840?

ASC 840, the former US GAAP lease accounting standard, was designed to classify leases as either capital or operating leases, shaping their treatment on financial statements. A key limitation of ASC 840 was its exclusion of operating leases from the balance sheet, which often led to under-reported financial obligations. Despite its historical role, ASC 840’s principles still resonate in audits and transitional phases.

Lease Classification Under ASC 840

One of ASC 840's cornerstone features is its lease classification, which determines whether a lease is capitalized or treated as an operating lease. This classification hinges on four critical tests:

1. Ownership Transfer: If ownership transfers to the lessee at the end of the lease term, it’s a capital lease.
2. Bargain Purchase Option: The lease includes an option for the lessee to buy the asset at a significantly lower price than its fair value.
3. Lease Term: The lease lasts for 75% or more of the asset's useful life.
4. Present Value: The present value of minimum lease payments equals or exceeds 90% of the asset's fair value.

If none of these criteria are met, the lease is classified as an operating lease, recorded off the balance sheet, with periodic rent expenses disclosed.

Accounting for Capital Leases

Under ASC 840, capital leases are recognized on the balance sheet. Here’s how:

• Right-of-Use Asset: Debited for the asset's value.
• Lease Liability: Credited as a liability reflecting the obligation.
• Expenses include depreciation on the asset and interest on the liability, which are recorded separately.

This dual-expense approach provides a clear picture of asset usage and cost obligations, making capital leases more transparent than their operating counterparts.

Operating Leases and Off-Balance Sheet Treatment

Operating leases, on the other hand, are treated differently under ASC 840. They remain off the balance sheet, with rent expenses recorded on a straight-line basis. For example:

• Monthly rent payments are accounted for as debit: rent expense and credit: cash. Although operating leases didn’t affect the balance sheet, companies were required to disclose future obligations in the financial statement notes—a practice often criticized for its lack of visibility.

Key Exclusions from ASC 840

Not all contracts qualify as leases under ASC 840. The following are excluded:

• Leases for inventory or construction-in-progress assets.
• Intangible assets like software licenses.
• Natural resources or biological assets, such as leases for timberland or farming properties.

By defining these exclusions, ASC 840 ensured clarity on its scope, helping businesses avoid misclassification and incorrect reporting.

Modifications and Terminations in ASC 840

Lease modifications and terminations were another critical aspect. ASC 840 required companies to reassess lease classification only if:

• A significant change, such as the exercise of an option, occurred.
• Modifications altered the terms enough to change the lease's classification criteria.

If no reassessment was needed, the lease continued under its original classification, simplifying the accounting process.

Transition to ASC 842: A Paradigm Shift

The limitations of ASC 840, particularly its off-balance sheet treatment of operating leases, spurred the transition to ASC 842. The new standard addressed transparency concerns by requiring nearly all leases to be recognized on the balance sheet. Public companies transitioned by 2019, while private companies had until 2022, with extensions granted for the pandemic’s impact.

ASC 842 brought several key changes, including:

• Removal of bright-line tests for lease classification.
• Introduction of finance leases replacing capital leases.
• Mandatory disclosure of right-of-use assets and lease liabilities.

Key Differences Between ASC 840 and ASC 842

The shift from ASC 840 to ASC 842 introduced significant changes in lease accounting, making it essential to understand their differences:

1. Balance Sheet Recognition

Under ASC 840, operating leases were off-balance sheet, disclosed only in financial statement notes. ASC 842 requires all leases (except short-term leases) to be recognized on the balance sheet as right-of-use assets and lease liabilities, ensuring greater transparency.

2. Lease Classification

ASC 840 classified leases as capital or operating using four strict criteria. ASC 842 retains these criteria but removes the bright-line thresholds of 75% and 90%. Instead, it focuses on whether the lease represents a "major part" of the asset's useful life or "substantially all" of its fair value.

3. Discount Rate

ASC 840 relied on the lessee’s incremental borrowing rate or the rate implicit in the lease, which was often derived from Treasury rates. ASC 842 redefines the incremental borrowing rate and allows private companies to use a practical expedient: the risk-free rate.

4. Deferred Rent

ASC 840 required deferred rent accounts for operating leases when rent payments varied over the lease term. ASC 842 eliminates deferred rent by adjusting the right-of-use asset instead.

Practical Implications of ASC 840’s Legacy

While ASC 842 has taken center stage, ASC 840’s principles continue to play a role in:

• Historical Audits: For financial periods before the adoption of ASC 842, understanding ASC 840 remains crucial.
• Financial Comparisons: Evaluating year-over-year performance often requires analyzing financials prepared under both standards.
• Transition Guidance: Companies still in the process of transition rely on ASC 840 to understand how and why classifications have changed.

ASC 840 Lease Modifications: A Closer Look

Under ASC 840, lease modifications required careful assessment. Companies needed to consider two primary tests:

1. Classification Test: Did the modification alter the lease enough to change its classification from capital to operating or vice versa?
2. Measurement Test: Were the changes substantial enough to require remeasurement of lease liabilities?

If a modification met either criterion, it was treated as a new lease for accounting purposes.

ASC 840 to ASC 842 Transition

The transition process involves several key steps:

1. Lease Inventory: Identify all lease agreements, including embedded leases within broader contracts.
2. Classification Reassessment: Apply ASC 842’s new classification criteria to determine whether leases are finance or operating.
3. Data Collection: Gather key details such as lease payments, discount rates, and terms to calculate right-of-use assets and liabilities.
4. System Updates: Transitioning to ASC 842 often requires updates to accounting systems to accommodate new reporting requirements.

For companies transitioning, compliance with the PROPOSED ACCOUNTING STANDARDS UPDATE—LEASES (TOPIC 840) ensures accuracy in retrospective reporting.

Why Understanding ASC 840 Still Matters?

Despite its replacement, ASC 840 continues to hold relevance for:

• Stakeholder Communication: Investors and regulators often reference historical financials prepared under ASC 840.
• Smooth Transition: Companies in industries with complex leasing structures benefit from a solid grasp of ASC 840 as they refine their ASC 842 compliance.

ASC 840 serves as a foundation for understanding lease accounting and the rationale behind the significant updates in ASC 842.

Building on ASC 840 for Future Success

ASC 840 laid the groundwork for modern lease accounting, and while ASC 842 has redefined the landscape, mastering ASC 840 is essential for historical accuracy and smooth transitions. By understanding its classification, recognition, and disclosure requirements, businesses can ensure their financial reporting meets both past and present standards. With the knowledge of ASC 840 in your toolkit, your organization is better positioned for compliance, transparency, and informed decision-making.