ASC 840: Lease Classification and Accounting Rules

Accounting Standards Codification (ASC) 840, “Leases,” was the authoritative guidance for lease accounting under United States Generally Accepted Accounting Principles (U.S. GAAP) for many years. Issued by the Financial Accounting Standards Board (FASB), its primary role was to establish the rules for how companies recorded and reported their lease agreements. This standard has been formally superseded by ASC 842 for nearly all entities, making an understanding of its framework important for analyzing historical financial statements.

The core function of ASC 840 was to differentiate leases into two distinct categories: operating leases and capital leases. This classification was determined at the beginning of the lease and dictated how the transaction was reflected in a company’s financial statements. The two types of leases received vastly different accounting treatments, which had a substantial impact on key financial metrics and a company’s reported financial position.

Lease Classification Criteria

Under ASC 840, a lease agreement was subjected to four specific “bright-line” tests at its inception to determine its classification. If a lease met any one of these four criteria, it was required to be classified as a capital lease; otherwise, it was treated as an operating lease. This rules-based approach left little room for judgment and determined whether the lease was treated as a rental or as a financed purchase of an asset.

The first criterion was the ownership transfer test. This test was met if the lease agreement specified that legal ownership of the leased asset automatically transferred from the lessor to the lessee by the end of the lease term.

A second criterion involved the presence of a bargain purchase option. This was a provision that gave the lessee the right to purchase the leased asset at the end of the lease term for a price significantly below its expected fair market value, making it a capital lease.

The economic life test provided a quantitative measure. If the lease term was equal to 75% or more of the asset’s estimated economic life, the lease was classified as a capital lease. This test was based on the principle that if a lessee used an asset for the majority of its useful life, the transaction was economically similar to ownership.

Finally, the fair value test focused on the financial substance of the transaction. This test required calculating the present value of all minimum lease payments. If this present value was equal to 90% or more of the leased asset’s fair market value at the start of the lease, it was a capital lease.

Accounting for Operating Leases

When a lease did not meet any of the four criteria for a capital lease, it was classified as an operating lease. The accounting for operating leases was often referred to as “off-balance-sheet financing” because neither the leased asset nor the obligation for future lease payments was recorded on the company’s balance sheet.

The primary impact of an operating lease was on the income statement. Lease payments were recognized as rent expense over the lease term, typically on a straight-line basis. For instance, if a lease agreement included escalating payments over its term, the company would still calculate a single, average periodic expense to report.

Accounting for Capital Leases

The accounting for a capital lease under ASC 840 was designed to reflect the transaction’s substance as a financed purchase. When a lease was classified as a capital lease, it had a significant impact on both the balance sheet and the income statement. This treatment acknowledged that the lessee had effectively acquired an asset and incurred a liability to pay for it over time.

At the commencement of a capital lease, the lessee was required to record an asset and a corresponding liability on its balance sheet. The value recorded for both was the lower of either the fair market value of the asset or the present value of the minimum lease payments.

The income statement impact was also more complex. Instead of a single rent expense, the lessee recognized two separate expenses over the life of the lease: depreciation expense and interest expense. The capitalized asset was depreciated over the lease term, while the lease liability was treated like a loan. Each lease payment was allocated between a reduction of the principal liability and an interest expense component. This dual-expense recognition meant that the total expense reported in the early years of a capital lease was typically higher than in the later years.

Required Financial Statement Disclosures

Regardless of the lease classification, ASC 840 mandated specific disclosures in the footnotes of the financial statements to provide users with additional information about a company’s leasing activities. These disclosures were intended to offer transparency beyond the numbers presented on the balance sheet and income statement.

For both operating and capital leases, companies were required to provide a general description of their leasing arrangements. This included information about the types of property being leased, the basis for any contingent rental payments, and the existence and terms of renewal or purchase options. The most significant disclosure was a schedule of future minimum lease payments. Companies had to report the total payments required for each of the next five fiscal years and a single aggregate amount for all years thereafter.

For capital leases, the disclosures were more extensive to reflect the on-balance-sheet nature of the obligation. In addition to the schedule of future minimum payments, companies had to disclose the gross amount of assets recorded under capital leases, presented by major property categories. They also had to report the accumulated depreciation on these assets.

The Shift to ASC 842

The framework of ASC 840 faced growing criticism, primarily centered on the off-balance-sheet nature of operating leases. Critics argued that excluding significant lease obligations from the balance sheet obscured a company’s true financial leverage and risk. A company could be committed to making billions of dollars in future lease payments, yet these obligations would only be visible in the footnotes, making it difficult to compare companies accurately.

In response, the FASB issued ASC 842, Leases, which replaced ASC 840. The new standard became effective for public companies for fiscal years beginning after December 15, 2018. The most fundamental change was the requirement for lessees to recognize assets and liabilities for nearly all leases, including those that would have been classified as operating leases under the old rules.

Under ASC 842, leases are still classified as either operating or finance (a category similar to ASC 840’s capital leases). However, both types of leases now result in the recording of a “right-of-use” asset and a corresponding lease liability on the balance sheet. This change was designed to increase transparency and comparability by ensuring that financial statements reflect all leasing commitments.