Fasb asc 840

What Is FASB ASC 840?

FASB ASC 840 refers to the superseded accounting standard for leases, a critical component of financial reporting within Generally Accepted Accounting Principles (GAAP) in the United States. This standard, formally known as Accounting Standards Codification Topic 840, prescribed how companies should classify and account for lease agreements on their financial statements. Under FASB ASC 840, leases were primarily categorized as either operating leases or capital leases, with significant differences in how they impacted a company's balance sheet and income statement. FASB ASC 840 was part of the broader accounting standards category, aiming to provide a framework for consistent and transparent financial disclosures regarding leased assets.

History and Origin

The foundation for FASB ASC 840 can be traced back to Financial Accounting Standards Board (FASB) Statement No. 13 (FAS 13), issued in November 1976 and effective January 1, 1977. This standard aimed to provide guidance on lease accounting, replacing a patchwork of previous pronouncements. FAS 13, which later became codified as ASC 840, distinguished between operating leases and capital leases based on specific criteria designed to determine if the lease essentially transferred ownership or its benefits and risks to the lessee. For decades, FASB ASC 840 dictated that only capital leases were recognized as both an asset and a liability on the balance sheet, while operating lease obligations were typically disclosed only in the footnotes of financial statements. This approach, however, eventually led to significant criticism regarding a practice known as off-balance sheet financing, where substantial lease obligations were kept out of a company's primary financial statements, potentially obscuring a more accurate view of its financial health.¹⁰,⁹ The U.S. Securities and Exchange Commission (SEC) and other stakeholders expressed concerns about the lack of transparency, leading to calls for comprehensive reform.⁸,⁷ These concerns ultimately spurred the FASB to undertake a joint project with the International Accounting Standards Board (IASB), culminating in the issuance of ASC 842, which superseded FASB ASC 840 for most entities by 2019 or 2022.⁶

Key Takeaways

FASB ASC 840 was the prior U.S. GAAP standard for lease accounting, effective from 1977 until its replacement by ASC 842.
It classified leases primarily as either capital leases or operating leases.
Under FASB ASC 840, capital leases appeared on the balance sheet as assets and liabilities, while operating leases typically did not.
A major criticism of FASB ASC 840 was its allowance for significant off-balance sheet financing through operating leases, which impacted financial transparency.
The standard was superseded to enhance transparency and provide a more comprehensive view of a company's lease obligations.

Formula and Calculation

While FASB ASC 840 does not present a single overarching "formula" for lease accounting, it provided specific criteria that required quantitative calculations to determine whether a lease qualified as a capital lease or an operating lease. If any one of the following four criteria was met, the lease was classified as a capital lease; otherwise, it was an operating lease:

Transfer of Ownership: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
Bargain Purchase Option (BPO): The lease contains a bargain purchase option, allowing the lessee to purchase the asset at a significantly lower price than its expected fair value at the end of the lease term.
Lease Term Test: The lease term is equal to 75% or more of the estimated economic life of the leased asset.
Present Value Test: The present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased asset.

The calculation for the Present Value Test involved discounting future minimum lease payments.

PV = \sum_{t=1}^{n} \frac{P_t}{(1+r)^t}

Where:

(PV) = Present Value of minimum lease payments
(P_t) = Lease payment in period (t)
(r) = The discount rate (either the implicit rate in the lease, if known and practicable, or the lessee's incremental borrowing rate).
(n) = Lease term in periods

If (PV \ge 0.90 \times \text{Fair Value of Asset}), the lease was a capital lease.

Interpreting FASB ASC 840

Interpreting financial statements prepared under FASB ASC 840 required careful attention to lease classifications. For capital leases, a company recognized a Right-of-Use (ROU) Asset (though often referred to simply as a leased asset) and a corresponding lease liability on its balance sheet. The asset was then subject to depreciation (or amortization), and the liability was reduced over time with interest expense recognized on the income statement, similar to debt.

In contrast, under FASB ASC 840, operating leases were treated more like a rental expense. No asset or liability was generally recorded on the balance sheet for the lease itself. Instead, lease payments were recognized as rent expense on the income statement as they were incurred. This distinction was critical for financial analysis, as companies with substantial operating lease commitments might appear to have lower debt levels and higher asset turnover ratios than they truly did, leading to potential misrepresentation of their financial leverage and obligations. Analysts needed to scrutinize the footnotes of financial statements to uncover these off-balance sheet obligations to get a more complete picture of a company's financial position.

Hypothetical Example

Consider a hypothetical company, "Diversified Logistics Corp.," that leases a warehouse under a 10-year agreement with annual payments of $50,000. The estimated economic life of the warehouse is 15 years, and its fair value is $400,000. The company's incremental borrowing rate is 5%.

Under FASB ASC 840, Diversified Logistics Corp. would need to evaluate the lease against the four capital lease criteria:

Ownership Transfer: The lease agreement does not transfer ownership.
Bargain Purchase Option: The lease does not contain a bargain purchase option.
Lease Term Test: The lease term (10 years) is 66.7% of the economic life (15 years). Since 66.7% is less than 75%, this criterion is not met.
Present Value Test: Calculate the present value of the 10 annual payments of $50,000 discounted at 5%.

Using a present value annuity factor for 10 years at 5% (approximately 7.7217), the PV of minimum lease payments is:
(PV = $50,000 \times 7.7217 = $386,085)

Compare this to 90% of the fair value of the asset:
(0.90 \times $400,000 = $360,000)

Since $386,085 (PV of payments) is greater than $360,000 (90% of fair value), the Present Value Test is met.

Because at least one criterion (the Present Value Test) is met, Diversified Logistics Corp. would classify this as a capital lease under FASB ASC 840. Consequently, it would record an asset (the warehouse) and a corresponding liability on its balance sheet for $386,085. Over the 10-year lease term, the asset would be depreciated, and interest expense on the lease liability would be recognized, impacting the company's financial ratios.

If none of the criteria were met, it would have been an operating lease, and the $50,000 annual payment would simply be expensed as rent.

Practical Applications

FASB ASC 840 profoundly influenced corporate financial reporting for decades, particularly in industries heavily reliant on leased assets such as retail, transportation, and construction. Companies utilized the standard's distinctions to manage their balance sheets. For example, by structuring agreements to qualify as operating leases, businesses could avoid recognizing significant lease liabilities on their balance sheets. This practice, known as off-balance sheet financing, could make a company's debt-to-equity ratios appear more favorable and improve other financial metrics, potentially enhancing borrowing capacity or perceived financial health.⁵

Analysts and investors, aware of this, often had to perform extensive adjustments using information from financial statement footnotes to gain a truer understanding of a company's total financial obligations. For example, a company might lease a large fleet of vehicles or a chain of retail stores under operating lease arrangements. Under FASB ASC 840, these substantial obligations would not be reflected as assets or liabilities on the main financial statements, but rather as ongoing rent expenses on the income statement and future commitments disclosed in the notes. This required diligence from financial statement users to factor in these implicit debts when assessing solvency and financial risk.

Limitations and Criticisms

The primary and most significant criticism of FASB ASC 840 stemmed from its differential treatment of operating and capital leases, which enabled widespread off-balance sheet financing.⁴ Critics argued that this distinction allowed companies to obscure substantial contractual liabilities by structuring what were, in substance, financing arrangements as operating leases. This lack of transparency made it difficult for investors, creditors, and other stakeholders to accurately assess a company's true financial position, leverage, and risk.³

For instance, a company could lease a building for nearly its entire economic life, with payments equivalent to a mortgage, yet classify it as an operating lease under FASB ASC 840 if it narrowly avoided the capital lease criteria. This meant the obligation would not appear as debt on the balance sheet, making the company appear less leveraged than it actually was. This "accounting arbitrage" undermined the comparability of financial statements across companies and industries, particularly between those that owned assets and those that leased them. The issues of transparency and comparability ultimately led the FASB and the IASB to embark on a joint project to revise lease accounting, which resulted in the issuance of ASC 842.²

FASB ASC 840 vs. FASB ASC 842

FASB ASC 840 and FASB ASC 842 represent two distinct approaches to lease accounting under U.S. GAAP. The fundamental difference lies in their treatment of operating leases.

Under FASB ASC 840, leases were categorized into two main types: capital leases and operating leases. Capital leases were treated much like asset purchases, with both an asset (representing the right to use the leased property) and a corresponding liability (for future lease payments) recognized on the balance sheet. Operating leases, however, generally remained off-balance sheet; only the periodic lease payments were expensed on the income statement, and future obligations were disclosed in footnotes. This distinction led to the prevalence of off-balance sheet financing.

FASB ASC 842, the successor standard, largely eliminates the off-balance sheet treatment for operating leases for lessees. It mandates that nearly all leases with terms longer than 12 months require the recognition of a Right-of-Use (ROU) Asset and a corresponding lease liability on the balance sheet. While ASC 842 retains a classification system (finance leases, largely similar to capital leases, and operating leases), the key impact is that both types of leases now result in the recognition of assets and liabilities, significantly increasing transparency regarding a company's lease obligations.¹ This change aims to provide a more complete picture of a company's financial position to investors and other stakeholders.

FAQs

What was the main problem with FASB ASC 840?

The main problem with FASB ASC 840 was that it allowed companies to keep significant lease obligations, particularly those categorized as operating leases, off their balance sheet. This practice, known as off-balance sheet financing, could make a company appear less indebted than it truly was, potentially misleading investors and creditors about its actual financial leverage and risk.

When was FASB ASC 840 replaced?

FASB ASC 840 was replaced by ASC 842. The new standard became effective for public companies for fiscal years beginning after December 15, 2018 (i.e., January 1, 2019, for calendar-year companies), and for private companies and non-profit organizations for fiscal years beginning after December 15, 2021.

Did FASB ASC 840 apply to all types of leases?

FASB ASC 840 applied to most leases of property, plant, and equipment. However, certain types of agreements, such as leases of intangible assets, inventory, or biological assets, were generally outside its scope. The standard focused on determining whether an agreement for the right to use an identified asset qualified as a capital lease or an operating lease.

How did FASB ASC 840 affect a company's financial ratios?

Under FASB ASC 840, operating leases did not result in recording a liability on the balance sheet. This meant that financial ratios that incorporate debt, such as the debt-to-equity ratio, could appear more favorable for companies with significant operating lease commitments compared to those that financed similar assets through traditional debt or capital leases. This distinction often required analysts to make adjustments when comparing companies.