What Was FASB Statement No. 13 for Lease Accounting?

The Financial Accounting Standards Board (FASB) establishes financial accounting and reporting standards for U.S. companies. For decades, the guiding principles for lease accounting were rooted in the Statement of Financial Accounting Standards No. 13 (FAS 13), issued in 1976. This standard, later known as ASC 840, dictated how companies reported lease transactions. It created a split in lease classification, treating some as simple rentals and others as financing transactions.

FAS 13 was the authoritative guidance for over 40 years, a period when leasing became an increasingly popular method for acquiring assets. The rules within FAS 13 allowed many lease obligations to remain off a company’s balance sheet. This practice, while compliant at the time, was later viewed as lacking transparency for investors. This led the FASB to issue a new standard, ASC 842, which superseded FAS 13 and changed lease accounting.

Lease Classification Under FAS 13

Under FAS 13, the classification of a lease by a lessee was a determination that influenced a company’s financial statements. Every lease had to be categorized as either a capital lease or an operating lease. This classification hinged on whether the lease transferred “substantially all of the benefits and risks incident to the ownership of property.” FAS 13 established four specific “bright-line” tests, and if a lease met just one, it was classified as a capital lease.

• The lease transferred legal ownership of the asset to the lessee by the end of the lease term.
• It included a bargain purchase option, allowing the lessee to buy the asset at a price significantly below its expected fair market value.
• The lease term was equal to 75% or more of the asset’s estimated economic life.
• The present value of the minimum lease payments equaled or exceeded 90% of the asset’s fair market value at the lease’s inception.

To illustrate, imagine a company leasing a machine with a 10-year economic life and a fair market value of $100,000. If the lease term is eight years, it would meet the 75% test, and the company would classify it as a capital lease. If none of the four criteria were met, the arrangement was an operating lease.

Lessee Accounting Treatment

The accounting treatment for a lessee depended entirely on the lease classification determined by the four bright-line tests. The distinction created two very different pictures of a company’s financial position and performance.

Capital Lease

When a lease was classified as a capital lease, the lessee was required to treat it as the acquisition of an asset and the incurrence of a liability. This meant the company would record an asset on its balance sheet, representing its right to use the property, and a corresponding liability for its obligation to make lease payments. In subsequent periods, the company would recognize depreciation expense on the asset and interest expense on the liability.

Operating Lease

In contrast, an operating lease was accounted for much more simply. Under FAS 13, an operating lease did not result in recording an asset or a liability on the lessee’s balance sheet. The lease payments were treated as a regular operating expense on the income statement. This accounting treatment was often preferred by companies because it did not increase the liabilities shown on their balance sheets, a practice known as “off-balance-sheet financing.”

Lessor Accounting Treatment

The accounting perspective for the lessor—the owner of the asset—also depended on a classification process under FAS 13. The lessor’s classification used the same four initial criteria as the lessee, plus two additional tests. This process led to three potential lease classifications for the lessor: sales-type, direct financing, or operating.

Sales-Type and Direct Financing Leases

A sales-type lease was common for manufacturers or dealers who used leasing as a way to sell their products. For these leases, the lessor would recognize a profit on the “sale” at the inception of the lease, in addition to interest income over the lease term. A direct financing lease did not involve a manufacturer’s or dealer’s profit and was entered into by financial institutions. The lessor would derecognize the asset and record a lease receivable, recognizing only interest income over the life of the lease.

Operating Lease

If a lease did not meet the criteria to be classified as a sales-type or direct financing lease, it was treated as an operating lease by the lessor. In this scenario, the lessor kept the asset on its balance sheet and continued to depreciate it. The lease payments received from the lessee were recognized as rental revenue over the lease term.

The Superseding Standard ASC 842

In 2016, the FASB issued Topic 842 (ASC 842), a new lease accounting standard designed to replace FAS 13 (codified as ASC 840) and address its shortcomings. The primary objective of ASC 842 was to increase transparency and comparability by requiring the recognition of lease assets and lease liabilities for most leases.

The standard is now fully in effect for both public and private companies. Under ASC 842, lessees still classify leases, but the categories are now “finance leases” (the successor to capital leases) and “operating leases.” The main change is that both classifications now require a lessee to record a right-of-use (ROU) asset and a corresponding lease liability on the balance sheet. The only exception is for short-term leases, defined as those with a term of 12 months or less.

Key Differences from FAS 13

The transition from FAS 13 to ASC 842 introduced several major changes, but the most impactful was the shift in balance sheet treatment for lessees. This change was driven by the desire to eliminate the off-balance-sheet financing associated with operating leases under FAS 13.

The most significant distinction is that under ASC 842, operating leases are now recorded on the balance sheet. While FAS 13 allowed these leases to be treated as simple expenses with only footnote disclosure, ASC 842 mandates the recognition of a right-of-use asset and a lease liability. This change increases the assets and liabilities on the balance sheets of companies with significant operating lease portfolios.

Another difference lies in the classification criteria. FAS 13 was known for its rigid, “bright-line” tests, such as the 75% of economic life and 90% of fair value rules. ASC 842 moved toward a more principles-based approach. While the new standard’s finance lease tests are largely consistent with the old capital lease criteria, they are framed as general principles rather than strict percentage thresholds, requiring companies to use more judgment in classifying their leases.