Companies with operating leases might not like having to report their lease liability on the balance sheet to comply with ASC 842 guidelines, but there’s a silver lining: Analysts and potential investors may see them as having less liabilities.
Under ASC 840, analysts can’t fairly compare the balance sheet of a company with a capital lease—or a company with an owned asset financed with debt—to one with an operating lease. Capital lease liabilities and liabilities from assets financed with debt are represented on the balance sheet, but under 840 operating lease liabilities are not. So analysts must guesstimate the amount of operating lease liabilities. To do that, they turn to the annual income statement.
On the income statement, analysts find operating lease expense for the year. Analysts typically assume if they multiply annual lease expense by seven—to represent an average lease term combined with an average discount rate—that will give them a conservative estimate of the operating lease liability, the present value of the lease cost for the remaining lease term.
However, FASB found that multiplying the annual lease liability by seven might be too conservative.
In a December FASB meeting, board member Gary Buesser said, “Under 842, the median lease liability multiple, according to our XBRL team’s data analysis of 1,400 companies, is 3.5 times.”
When FASB looked at the actual operating lease liabilities that companies are now posting on their balance sheets, the median lease liability is now half what it would have been based on the typical formula used to guesstimate the lease liability. So, companies with operating leases that are still following ASC 840 may benefit by moving to ASC 842. The deadline to comply with 842 has passed for public companies, but private companies and private not-for-profit entities aren’t required to adopt the guidelines until Dec. 15, 2021.
ASC 840 v. ASC 842
To understand how ASC 842 may benefit companies with operating leases, it’s important to know a couple of differences between ASC 840 and ASC 842.
- Under 840, lessees have to classify their leases as either an operating lease or a capital lease.
- Under 842, lessees have to classify their leases as either an operating lease or a finance lease.
- A finance lease is basically the same as a capital lease. FASB changed the name from a “capital lease” to a “finance lease” to match the name used by the International Financial Reporting Standards (IFRS). The conditions that must be met to classify a lease as a capital lease or a finance lease are nearly the same and are listed at the bottom of this blog post.
- Under 842, assets recorded for finance and operating leases are called Right of Use assets.
Major Financial Statement Presentation Differences
|Financial Statement||Standard||Capital-ASC 840/Finance Lease-ASC 842||Operating Lease|
|Balance Sheet||ASC 840||Record the lease asset and lease liability.||No lease asset or liability is to be recorded on the balance sheet.|
|Balance Sheet||ASC 842||The ROU asset and lease liability are to be reported on the balance sheet.||The ROU asset and lease liability are to be reported on the balance sheet.|
|Income Statement||ASC 840||Lessees should recognize interest expense on the lease liability separately from depreciation expense on the lease asset.||Record a single lease cost, calculated so that the cost is allocated over the lease term, typically as a straight-line expense.|
|Income Statement||ASC 842||Lessees should recognize interest expense on the lease liability separately from depreciation expense on the lease asset.||Record a single lease cost, calculated so that the cost is allocated over the lease term, typically as a straight-line expense.|
Under 840 and 842, lessees must classify leases into one of two categories. The first category is a capital lease (the term used under ASC 840) or a finance lease (the term used under 842). The second category is an operating lease (a term under both standards). Under both guidelines, leases are considered to be operating leases unless they meet one of the following four conditions:
- A transfer of ownership of the asset at the end of the term
- An option to purchase the asset at the end of the term that the lessee expects to exercise (a bargain purchase option under 840)
- The lease term is greater than or equal to 75% of the useful life of the asset (842 changed the 75% to “major part,” but most are still using 75%, and FASB said this is reasonable)
- The present value of the lease payments is greater than or equal to 90% of the asset’s fair market value (842 changed the 90% to “substantially all,” but most are still using 90%, and FASB said this is reasonable)
ASC 842 added a fifth test: 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.
If a lease meets any one of those conditions, under ASC 840 it is to be classified as a capital lease, and under ASC 842 it is to be classified as a finance lease.