Figure LG 1-2 summarizes the significant differences between ASC 842 and the previous guidance in ASC 840.
Figure LG 1-2
Changes to lease accounting under ASC 842
ASC 842 guidance
Definition of a lease
An arrangement is a lease or contains a lease only when such arrangement conveys the right to “control” the use of an “identified asset” to a customer and the customer obtains substantially all its economic benefits
Under ASC 840, an arrangement can contain a lease even without control of the use of the asset if the customer takes substantially all of the output over the term of the arrangement.
Determining whether an arrangement contains a lease is likely to be more important since virtually all leases will require recognition of an asset and liability by a lessee. It will also make the allocation of contractual consideration between lease and nonlease components a critical element of the accounting analysis for many reporting entities.
Lessee accounting
There are no bright lines and there is one additional criterion regarding the specialized nature of the underlying asset for lease classification
The lack of explicit bright lines will increase the level of judgment required when classifying a lease – particularly for certain highly structured transactions. Despite the removal of the bright lines, the guidance in ASC 842-10-55-2 acknowledges that one reasonable approach to determining whether the lease is for a major portion of the asset’s remaining economic life and whether lease payments represent substantially all of the asset’s fair value is the 75% and 90% thresholds, respectively, applicable in ASC 840.
Lessees will recognize a right-of-use asset and a lease liability for virtually all leases
Reflecting nearly all leases on the balance sheet is the biggest change, and one of the key objectives of the guidance in ASC 842.
Expense will be recognized on a straight-line basis for an operating lease. This is accomplished by increasing the amortization of the right-of-use asset as the imputed interest on the liability declines over the lease term. Recognition of expense for a finance lease will be similar to capital leases in ASC 840.
Under ASC 840, operating leases are off-balance sheet. Under ASC 842, the accounting for an operating lease will backload amortization of the right-of-use asset, potentially increasing the risk of an impairment. Once impaired, the right-of-use asset in an operating lease will be amortized on a straight-line basis, which will result in an expense recognition pattern similar to a finance lease.
Lessor accounting
The classification criteria are similar to that for lessees, with an additional requirement to assess collectibility to support classification as a direct financing lease. Also, in order to derecognize the asset and record revenue, collection of payments due must be probable for sales-type leases.
To recognize upfront revenue and profit in a sales-type lease, the lessee will need to obtain control over the leased asset.
Leases otherwise classified as a sales-type or direct financing lease must be accounted for as an operating lease if they contain variable lease payments that don’t relate to a rate or index and would result in recognition of a day-one loss. This accounting model is similar to ASC 840.
Under ASC 840, to achieve sales-type lease accounting for real estate, title must automatically transfer to the lessee by the end of the lease term. This condition has been removed from the guidance in ASC 842.
In ASC 840, the difference between a sales-type lease and a direct finance lease is the presence of upfront profit. When present, the arrangement is a sales-type lease.
Under ASC 842, the key distinction is based on control. As a practical matter, this will likely depend on whether the lease payments criterion has been met in part due to a third-party residual value guarantee. When this is the case, assuming payments are collectible, the lease is classified as a direct financing lease.
Lease versus nonlease components
A contract may contain lease and nonlease components. Under ASC 842, components include only those items or activities that transfer a good or service to the lessee.
A lessee may choose not to separate nonlease components from their associated lease components. If this election is made, all cash flows associated with the nonlease component would be allocated to the associated lease component. A lessor may elect to combine nonlease and associated lease components when the timing and pattern of transfer of the components are identical, and the lease classification would have been an operating lease absent the combination. If elected, the combined components would be accounted for under ASC 842 only if the nonlease component is not predominant.
The right to use land is considered a separate lease component unless the accounting effect of accounting for it separately would be immaterial.
Under ASC 840, property taxes and insurance are considered executory costs. Under ASC 842, property taxes and insurance are not considered as components of a contract as they are not for a service provided by the lessor to the lessee, and are therefore a part of contract payments if the contract requires the lessee to reimburse the lessor for those costs.
Under ASC 840, land is separately classified when the fair value of the land is 25% or more of the combined fair value of the land and building.
Inception date versus commencement date
Under ASC 842, the determination of whether or not a contract is a lease or contains a lease is done at the inception date. Lease classification is determined, and the lease is recognized and measured, at the lease commencement date.
Under ASC 840, assumptions relevant to classification and measurement are determined at lease inception. Recognition of rent expense or capital lease assets and liabilities begin at the commencement date.
Initial direct costs
Under ASC 842, initial direct costs are defined as incremental costs of a lease that would not have been incurred if the lease had not been obtained.
Under ASC 840, incremental direct costs can include internal costs as well as external costs such as legal fees, even if incurred before the lease was obtained. Therefore, certain incremental costs previously eligible for capitalization will be expensed under ASC 842.
Build-to-suit arrangements
Ownership during construction period is based on a control model.
ASC 840 guidance is based on a risks and rewards model, but contains several complex prescriptive provisions designed to assess lessee ownership during construction. The ASC 842 model has eliminated these prescriptive rules and replaced them with a model based on control.
Under ASC 840, build-to-suit accounting applies only to lessees. Under ASC 842, build-to-suit accounting also applies to lessors.
Sale and leaseback transactions
Under ASC 842, a sale and leaseback transaction will qualify as a sale only if:
  • it meets the sale guidance in the revenue standard,
  • the leaseback is not a finance lease for a lessee or a sales-type lease for a lessor, and
  • if there is a repurchase option,
o the repurchase price is at the underlying asset’s fair value at the time of exercise and
o alternative assets that are substantially the same as the transferred asset are readily available in the marketplace.
Under ASC 840, sale and leaseback accounting is applicable only to lessees. This includes detailed and specialized guidance applicable to sale and leasebacks involving real estate.
Under ASC 842, sale and leaseback accounting will apply to lessees and lessors. A “failed” sale is treated as a financing by both the lessee and lessor (i.e., the seller has not sold the asset but has essentially mortgaged it). There is no specialized guidance for sale and leasebacks of real estate. However, a sale and leaseback for real estate that includes a repurchase option will likely fail sale accounting (as it did before ASC 842) because all real estate is unique and no other asset would be substantially the same.
Sale and leaseback transactions involving equipment frequently have fixed price repurchase options – often at the request of the seller-lessee for commercial reasons. Such transactions will not qualify as a sale under the new standard. However, sale and leaseback accounting applied for transactions executed prior to the application date of ASC 842 will not need to be reevaluated. Existing “failed” sale and leaseback transactions will be evaluated under the new standard and may qualify for sale and leaseback accounting on transition.
Lessee reassessment
A lessee is required to reassess the lease term if a triggering event occurs that is under the lessee’s control or an option is exercised/not exercised as planned or an event written in the contract occurs that obligates the lessee to exercise/not exercise an extension or termination option. A change to the lease term will lead to a reassessment of lease classification and remeasurement of the lease liability and right-of-use asset. Assumptions such as the discount rate, fair value of the underlying asset, and variable rents based on a rate or index will be updated as of the remeasurement date.
ASC 840 does not require a reassessment of lease classification unless the lease is modified or an option is exercised. Under ASC 842, a lessee will need to monitor for triggering events on an ongoing basis.
A lease modification is a change to the contractual terms and conditions of a lease that was not part of the original lease. A modification that grants the lessee an additional right of use priced at market is a separate lease that is then classified at the lease modification date. For all other modifications, entities may have to reassess whether the arrangement contains a lease, reallocate contract consideration between the lease and nonlease components, reassess lease classification, and remeasure the lease liability and right-of-use asset prospectively. Assumptions such as the discount rate, fair value of the underlying asset, and variable rents based on a rate or index will be updated as of the modification date.
Lease modifications under ASC 840 can be complex and difficult to differentiate from a termination of a lease contract. A renewal or extension is considered a new lease. All other changes are subject to a two-step evaluation of the lease.
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