ASC 606 and ASC 842 (Leases)

Accounting Standards Codification (ASC) 842 – Leases came as a response to the mistreatment of items on the balance sheet. At the beginning of the twenty-first century, multiple very large public companies were pursued by the government for fraudulent financial reporting. As a result, the US government introduced the Sarbanes-Oxley act in 2002 to promote transparency. This bill was later joined by ASC 840 published in 2010 and later ASC 842 in 2016, also known as Accounting Standards Update (ASU) 2016-02—Leases. These standards outline the proper accounting treatment for leased assets. This article will outline the relevance of ASC 842, review the comparative roles of both ASC 842 and ASC 606—Revenue, and consider the different interactions that can occur between the two.

ASC 842—Leases

The Financial Accounting Standards Board (FASB) updated ASC 840—Leases, based on ASU 2016-02 to clarify the accounting for and classification of the types of leases. Under ASC 840, leases would be classified as operating and would not appear in the financial statements beyond a mention in the footnotes. This allowed for a lot of subversive flexibility, and the new standard was meant to combat that. Nearly all leases show up on the financial statements, allowing for a more accurate representation of what future payment obligations a company possesses.

Other differences include assessing costs embedded in the contract, standards classifying leases, determining a Company’s borrowing rate, and recognizing leases using fair value principles. These will be further discussed in the section below.

ASC 842 and IFRS

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A few differences exist between the joint ruling of IFRS and GAAP. IFRS allows for companies to ignore the recognition of leases with an individual approximate value of $5,0001 and below,2 even if the aggregate becomes material. GAAP, unlike IFRS, requires companies to determine if an item falls under finance or operating lease classifications. IFRS users are required to remeasure the lease liability when the cash flows change based on an index, while GAAP recognizes these variable rates as applying to variable lease expenses. On October 2020, the FASB issued an exposure draft calling for feedback partially focused on lease liabilities. The goal of ASC 842 is to become more streamlined with this idea alongside IFRS 16. This proposal is currently being reevaluated, and there has been a proposed ASU allowing companies to recognize these liabilities with a similar method used in IFRS. Another major difference between the two standards is with repurchase options. If there is a substantive option to repurchase, IFRS does not allow a sale. GAAP, on the other hand, may allow a sale under certain circumstances. These are but a few of the differences, even if across the board these two standards are generally similar.

Rule	IFRS	GAAP
Minimal Value Leases	Leases individually costing below $5,000 may be ignored on the balance sheet	All individual leases must be accounted for on the financial statements
Classification	No required distinction between different leases	Required determination between operating or finance leases
Variable Lease Payments	Lease payments based off an index or other variable	Currently does not recognize variable lease payments

ASC 842 and ASC 840

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As mentioned above, there are a few items that differentiate the old and new standards. The goal for both standards is transparency for financial statement users, especially when it comes to determining the value of operating leases.3 The first big difference between ASC 840 and ASC 842 is the timing of lease classification. Under the previous standard, the classification was determined upon lease execution, while under ASC 842, classification is to be determined at lease commencement. This determination tends to require a certain amount of judgment depending on identified assets, right of control, and period of consideration.4ASC 842 also introduced the difference between lease and non-lease components by focusing on the practical expedient to join the two together under situations which will be discussed later in this article. The classification criteria were modified in the new standard to attempt to depict the most accurate representation. One other significant change is residual values were not used in the updated standard for determining the lease liability. The standard update was intended to clarify and better depict what is being done on the balance sheet.

Rule	ASC 840	ASC 842
Classification	Classification decided at lease execution	Classification decided at lease commencement
Practical Expedient	All executory costs (some would be included in non-lease components) were accounted for separately from the lease	A company can elect to include the non-lease components as part of the singular lease
Classification Criteria	Four specific lease requirements	Five lease requirements focusing more highly on judgement

The Roles of ASC 606 and ASC 842 in Contracts

First, it may be helpful to review the five steps of ASC 606: Revenue Recognition. To learn more about these steps than we have time for here, read The Five-Step Method.

5-Step Revenue Process

When identifying the contract and performance obligations, it is important to analyze the different components of a lease. ASC 842-10-25-2 specifies various circumstances under which an item may be classified as a finance lease:

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments, in accordance with paragraph 842-10-30-5(f), equals or exceeds substantially all of the fair value of the underlying asset.
The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

These requirements assist companies in determining how a lease should be reported. Once the classification has been determined, companies can begin to analyze the performance obligations that exist. These obligations could include insurance, taxes, or maintenance. When these are determined, the company can recognize the lease under ASC 842 and the non-lease components under ASC 606—Revenue. We will discuss the practical expedient involved in a later section.

Combination of Lease and Non-Lease Components

Once the underlying asset has been recognized as a lease, the components must be separated out unless the company elects to take the practical expedient. Lease components must meet both criteria from ASC 842-10-15-28 to be recognized:

The lessee can benefit from the right of use either on its own, or together with other resources that are readily available to the lessee.
The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract.

When the standard describes “right of use,” it means the lease asset being used by the company. Often the company has tools at its disposal which augment the use of the asset. These would not be included in the lease since they did not come as part of the contract. Some examples of things that could be in the contract, but be counted as non-lease components, are insurance related to the item, maintenance offered by the selling company, and warranties.

Practical Expedient Over Lease Component Combination

An option that ASC 842 permits is to recognize the lease and non-lease components as a singular asset or liability. This practical expedient simplifies the process since it relieves the company from performing a price allocation, but it will leave the lease to be a larger single item on the balance sheet. This also requires public companies to disclose what kind of assets were not separated out. A group from Deloitte found that it was fairly common for companies to make this election, but the practical expedient was applied to specific leases in the company, and not for all leased assets.⁵

Repurchase and Renewal Agreements

Under ASC 840, many companies benefited from leaseback transactions. This occurs when a company sells an asset and then leases it from the buyer. For example, assume Syndis Co. (seller-lessee) sells an office building to Hulders Co. (buyer-lessor) for $5 million. The asset no longer appears on Syndis Co.’s balance sheet. Syndis Co. then leases back the building from Hulders Co. as an operating lease, allowing it to keep the building off its books while still using the asset.⁶ With the ASC 842 update, the lease remains on Syndis Co.’s balance sheet, but there are still some advantages to the transaction.

The difficulty inherent in leaseback transactions lies in the recognition of the repurchase agreement. When these transactions take place, there is a clause that allows the seller-lessee to buy back the asset after a set amount of time, sometimes at a set price. This repurchase agreement comes under scrutiny when determining if the sale of the building to the buyer-lessor party is considered a sale or a failed sale. In the case of a failed sale, or if the terms of the arrangement would be similar if the company had not sold the building in the first place, the lease would count as a financing agreement instead of a sale. To learn more about this topic, see our article, Repurchase Agreements.

Implications for Businesses Implementing ASC 842

As companies have adopted the ASC 842 standard, there has been a significant impact on public companies’ financial reporting.

As operating leases have been added to the balance statement, assets for lessors and lessees have increased. Lessees’ liabilities have also increased. When comparing to commonly held measures, financial statement issuers and the financial statement users should recognize the impact the new standard has on comparative ratios. For example, a company that has been consistently profitable may rapidly lower or increase its debt to equity, when for the company, virtually nothing has changed. This is a prime example of an economic change, not a physical one.

Microsoft was an early adopter of the lease standard, applying it to its financials in 2018. On an earnings call, the Chief Accounting Officer described the impact of the new standard on the company:

We will now record our operating leases, related to datacenters, offices, research and development facilities, retail stores, and various equipment, under the operating lease right-of-use assets, other current liabilities, and operating lease liabilities lines in the balance sheet. This results in a net increase in assets and liabilities of $6.6 billion as of June 30, 2017 and a net increase in assets and liabilities of $5.2 billion as of June 30, 2016. As, I previously stated, this change will have no impact on our income statement or cash flows.

For uniformity, Microsoft elected to publish the comparative financials for the previous two years as if the standard had been in place for that time. In the end, the operating leases added 5% to Microsoft’s long-term assets and about 2% to its total assets. This can seem negligible, but when considering the high dollar impact on Microsoft’s balance sheet and the sensitivity of certain financial ratios, it is important to be aware of these changes.

Norfolk Southern Corp (May 2019 Correspondence With the SEC Over ASC 842)

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In its correspondence with the SEC, Norfolk explained how it accounts for leases under ASC 842 as follows:

We elected the package of practical expedients under the transition guidance with respect to our implementation of Financial Accounting Standards Board Accounting Standards Codification (ASC) 842. As such, all leases entered into prior to January 1, 2019 were classified in accordance with the lease classification criteria provided for in paragraph ASC 840-10-25-1, while all leases entered into subsequent to adoption are classified in accordance with ASC 842. Specifically, we classify leases as a financing lease if any of the criteria in paragraph ASC 842-10-25-2 (a) through (e) are met, or as an operating lease if none of those criteria are met. None of the leases disclosed in footnote 8 within our Form 10-Q for the quarter ended March 31, 2019 contain:

Transfers of ownership of the underlying asset to us at the end of the lease term;
Options to purchase the underlying asset that we are reasonably certain to exercise;
Lease terms for the major part of the remaining economic life of the underlying asset;
Present values of the sum of the lease payments equal to or exceeding substantially all of the fair value of the underlying asset (we have determined that the term “substantially all” refers to an amount equal to or in excess of 90%); nor
Underlying assets of such a specialized nature that they are expected to have no alternative use to the lessor at the end of the lease term.

As such, these leases have been classified as operating leases.

Specifically, with respect to the third bullet above, we compare the total lease term (determined as the base lease term plus any renewal options that we are reasonably certain to exercise), to the remaining period over which the underlying asset is expected to be economically usable. If that amount is less than 75%, we would classify the lease as an operating lease as we do not believe that the threshold for “major part of the remaining economic life of the underlying asset” has been met. (May 2019)

Conclusion

ASC 842 has pushed companies to report more transparent financial information by requiring operating leases to be shown on the balance sheet. As companies continue to adopt this standard, it is important to recognize some of the intricacies in accounting for this standard as well as the effect it can have on the company. Recognizing the components of a lease, being aware of the several practical expedients available under the standard, and understanding the other lease purchasing options will allow a company to accurately account for leases. As this lease standard is applied, it will allow shareholders to be more informed and business management to make better informed decisions.

Resources Consulted

ASU 2016-02: “Leases (Topic 842).”
KPMG, “ASC 842 and IFRS 16 Top Differences.” January 2021.
Shemaria, Justin. Lease Query. “ASC 840 vs ASC 842: Differences between the Old and New Lease Accounting Standard.” February 2020.
EY, The Private Angle: “Navigating the accounting requirements of the new leases standard.” August 2020.
Deloitte, Heads Up: “Reasonably certain of your lease disclosures? Observations on first-quarter filings.” July 2019.
Rashty, Josef. The CPA Journal. “An Analysis of the New Sale and Leaseback Guidance.” September 2018.