Appendix C — Differences Between ASC 842 and Previous Guidance Under ASC 840

Substantive substitution rights

For a substitution right to be substantive and thus preclude lease accounting, the supplier must both (1) have the practical ability to substitute the asset and (2) economically benefit from the substitution. The concept of economically benefitting from the substitution is a new concept under ASC 842.

A lease does not exist if the supplier has the right and ability to substitute other PP&E to fulfill the arrangement. The supplier does not need to economically benefit from the substitution for lease accounting to be precluded (the substitution must be practicable and economically feasible).

Right to control the use of the asset

To control the use of the asset, the customer must have the right to (1) obtain substantially all of the economic benefits from using the asset and (2) direct the use of the asset (i.e., determine HAFWP the asset will be used throughout the period of use).

A customer does not need to both obtain substantially all of the economic benefits and direct the use of the asset to control the use of the asset. For example, the customer can control the use of the asset if (1) it obtains substantially all of the output or other utility generated by the asset and (2) the price it pays is neither contractually fixed per unit of output nor equal to the current market price of the output.

Separating land and other lease components

A lessee should account for land and buildings as separate lease components unless the accounting effect of doing so would be insignificant (e.g., there would be no impact on lease classification or the amount recognized for the land component would be insignificant).

When the lease meets either the transfer-of-ownership or bargain-purchase-price classification criteria, the lessee should account for the land and other assets separately. Otherwise, when the fair value of the land is 25 percent or more of the total fair value of the leased property at lease inception, the lessee should classify the land and other assets separately.

Separating lease and nonlease components

As a practical expedient,1 a lessee may elect not to separate lease components and nonlease components associated with those lease components in the contract. If this practical expedient is elected, the lessee must account for the combined components as a single lease component.

A similar practical expedient does not exist under ASC 840.

Maintenance

Maintenance services represent a nonlease component that must be separated from the lease component(s) in the contract (if the practical expedient described above is not elected).

Amounts paid by the lessee to the lessor for maintenance are generally considered executory costs.

Classification criteria

Lessee — There are two accounting models for leases, and the model will dictate the pattern of expense recognition associated with the lease. Therefore, a lessee must perform a lease classification assessment as of the commencement date.

Under ASC 842-10-25-2, a lessee must consider the following five criteria when assessing lease classification:

• Transfer of ownership.
• Bargain purchase option.
• Lease term is for a major part of the estimated economic life of the leased property.
• Present value of the lease payments is substantially all of the fair value of the leased property.
• The leased asset is so specialized that it would have no alternative use to the lessor at the end of the lease term.

If any one of the five criteria is met, the lease is classified as a finance lease; otherwise, the lease is classified as an operating lease.

Although the lease classification criteria under ASC 842 differ from those under ASC 840, the FASB has stated that an entity may use the bright lines established under ASC 840 when evaluating the more principles-based criteria in ASC 842.

Lessor — A lessor must perform a lease classification assessment as of the commencement date. The criteria governing when a lessor must classify a lease as a sales-type lease are the same as those that govern when a lessee must classify a lease as a finance lease (noted above). If none of these criteria are met, the lessor would classify the lease as a direct financing lease in accordance with ASC 842-10-25-3 if (1) the sum of the lease payments and any third-party guarantee of the residual value “equals or exceeds substantially all of the fair value of the underlying asset” and (2) “[i]t is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.” Otherwise, the lease would be classified as an operating lease.

In addition, ASC 842-10-25-3A requires a lessor to classify a lease with variable lease payments that do not depend on an index or rate as an operating lease at lease commencement if: (1) the lease would have been classified as a sales-type or direct financing lease in accordance with the classification criteria in ASC 842-10-25-2 and 25-3, respectively, and (2) the lessor would have recognized a selling loss on the lease commencement date.

Lessee — There are two accounting models for leases, and the model will dictate the pattern of expense recognition associated with the lease. Therefore, a lessee must perform a lease classification assessment as of the inception date.

Under ASC 840-10-25-1, a lessee must consider the following four criteria when assessing lease classification:

• Transfer of ownership.
• Bargain purchase option.
• Lease term is equal to 75 percent or more of the estimated economic life of the leased property.
• Present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased property.

If any one of the four criteria is met, the lease is classified as a capital lease; otherwise, the lease is classified as an operating lease.

ASC 840 includes special considerations related to situations in which the sole asset being leased is land. A lease of land is classified as an operating lease unless the transfer-of-ownership criterion or bargain purchase option criterion is met.

Lessor — A lessor must perform a lease classification assessment as of the inception date.

A lessor, when assessing the classification of the lease, must consider the four lease classification criteria described above and both of the following additional criteria in ASC 840-10-25-42:

• Collectibility of the minimum lease payments is reasonably predictable.
• No uncertainties are associated with the amount of unreimbursable costs yet to be incurred by the lessor under the lease. Important uncertainties might include commitments by the lessor to guarantee performance of the leased property in a manner more extensive than the typical product warranty or to effectively protect the lessee from obsolescence of the leased property.

If, as of the lease inception date, the lease meets any of the four lease classification criteria and both of the additional criteria, it will be classified as a sales-type lease, direct financing lease, leveraged lease, or operating lease as follows:

• Sales-type lease — If the lease gives rise to manufacturer’s or dealer’s profit (or loss) and either (1) involves real estate for which ownership is transferred to the lessee by the end of the lease term and the two additional criteria in ASC 840-10-25-2 are met or (2) does not involve real estate and any of the criteria in ASC 840-10-25-1 are met and both of the criteria in ASC 840-10-25-42 are met.
• Direct financing lease — If the lease (1) meets any of the criteria in ASC 840-10-25-1 and both of the criteria for sales-type lease classification, (2) does not result in manufacturer’s or dealer’s profit for the lessor, and (3) does not meet the definition of a leveraged lease.
• Leveraged lease — If the (1) lease meets the criteria for a direct financing lease; (2) lease involves at least three parties, including a lessee, long-term creditor, and lessor; (3) financing provided by the long-term creditor is nonrecourse to the lessor’s general credit; and (4) lessor’s net investment declines in the early years once the investment has been completed and rises during the later years of the lease.
• Operating lease — If the lease does not qualify as a sales-type, direct financing, or leveraged lease.

Lessors should apply the guidance in ASC 840-10-25-55 through 25-59 when the sole asset being leased is land.

Executory costs

Executory costs (e.g., reimbursement for a lessor’s property taxes and insurance) are allocated to both lease and nonlease components in the contract on the same basis as the other consideration in the contract. The portion of executory costs allocated to the lease component(s) in the contract is considered part of the lease payments (to the extent that the payments are fixed).

All executory costs are excluded from the determination of minimum lease payments for classification and measurement purposes.

Residual value guarantees

A lessee should include in the lease payments only the amount of the residual value guarantee that it is probable the lessee will owe at the end of the lease term.

A lessee should include in the minimum lease payments the full amount of the residual value guaranteed by the lessee.

Discount rate

A lessee should use the rate implicit in the lease if it is readily determinable, regardless of whether it is higher than the lessee’s incremental borrowing rate. The rate implicit in the lease takes into account the lessor’s initial direct costs.

If the rate implicit in the lease is not readily determinable, a lessee uses its incremental borrowing rate.

The incremental borrowing rate is the rate that the lessee would pay to borrow an amount equal to the lease payments on a collateralized basis over a similar term. In addition, the lessee’s incremental borrowing rate is the rate of interest that a lessee would have to pay to borrow on a collateralized basis and must reflect a secured borrowing rate.

Non-PBEs can elect a practical expedient to use a risk-free discount rate in lieu of an incremental borrowing rate.

A lessee should use the rate implicit in the lease if it is readily determinable, unless that rate exceeds the lessee’s incremental borrowing rate.

The rate implicit in the lease does not incorporate the lessor’s initial direct costs.

The incremental borrowing rate is the rate the lessee could obtain to borrow the funds necessary to purchase the underlying asset.

The lessee’s incremental borrowing rate may be unsecured if it is consistent with the financing that would have been obtained to purchase the underlying asset (and not leased). The lessee is not required to use a rate that takes collateral into account but should use a rate that is “determinable, reasonable, and consistent with the financing that would have been used in the particular circumstances,” regardless of whether the rate is secured.

Inception date vs. commencement date

A lease is classified and initially measured on the lease commencement date.

A lease is classified and initially measured on the lease inception date.

Lessee accounting

All leases (finance and operating) other than those that qualify for the short-term recognition exception must be recognized on the lessee’s balance sheet. A lessee recognizes a liability for its lease obligation under the lease and a corresponding asset representing its right to use the underlying asset over the lease term.

A lessee only recognizes capital leases on its balance sheet. Leases classified as operating leases are not recognized on a lessee’s balance sheet.

Sales-type vs. direct financing lease

The distinction between a sales-type lease and a direct financing lease is based on whether the lessee obtains control of the underlying asset. This assessment is not affected by the relationship of the fair value to the carrying amount of the underlying asset. If the lessee obtains control of the underlying asset, the lease is classified as a sales-type lease. If the lessee does not obtain control of the underlying asset (but the lessor relinquishes control), the lease is classified as a direct financing lease.

The distinction between a sales-type lease and a direct financing lease is based on whether there is a difference between the fair value and carrying amount of the underlying asset. If the fair value equals the carrying amount of the underlying asset, the lease is classified as a direct financing lease. Otherwise, the lease is classified as a sales-type lease.

Collectibility

Lessors should consider collectibility in accounting for their leases, and such consideration differs depending on whether the lease is classified as a sales-type, direct financing, or operating lease.

A lease can still be classified as a sales-type lease if there are collectibility concerns. For a sales-type lease to be recognized, collectibility of the lease payments must be probable (in a manner consistent with ASC 606).

The collectibility guidance for direct financing and operating leases is aligned with ASC 840 (i.e., if the lease is not a sales-type lease, the lease should be classified as an operating lease if collectibility of the lease payments and any residual value guarantee is not probable at lease commencement).

A lessor cannot recognize a capital lease unless collectibility of the minimum lease payments is reasonably predictable.

Lessor’s accounting for direct financing leases

A lessor must defer selling profit for a direct financing lease and recognize the deferred amount over the lease term.

Because a direct financing lease can only arise if the fair value equals the carrying amount of the underlying asset, no profit or loss arises under a direct financing lease.

Leases involving real estate

There is no unique guidance on classifying and accounting for leases involving real estate. Leases involving real estate are subject to the same general classification and measurement guidance as leases involving other PP&E.

Leases involving real estate are subject to specific guidance that is unique to real estate (e.g., the lessor will only classify a lease involving real estate as a sales-type lease if it meets the transfer-of-ownership criterion in ASC 840-10-25-1(a)).

Sale-and-leaseback arrangements

All assets are subject to the same sale-and-leaseback guidance (i.e., there is no unique guidance on sale-and-leaseback arrangements involving real estate).

An entity should assess the criteria in ASC 606 to determine whether a sale has occurred. A repurchase option precludes sale accounting unless (1) the option is priced at the fair value of the asset on the date of exercise and (2) alternative assets exist that are substantially the same as the transferred asset and are readily available in the marketplace.

The existence of a leaseback by itself would not indicate that a sale has not occurred unless the leaseback is classified as a finance lease.

There is specific guidance on sale-and-leaseback arrangements involving real estate (including integral equipment).

A sale-and-leaseback arrangement involving nonintegral equipment that includes a repurchase option may not result in a failed sale if the option does not economically compel the seller-lessee to repurchase the equipment.

Leveraged lease accounting

ASC 842 does not include guidance on leveraged leases. Entities are not permitted to account for any new lease arrangements as leveraged leases after the effective date of ASC 842.

Leveraged leases existing as of the effective date of ASC 842 would be subject to the guidance in ASC 842-50, which is generally consistent with the legacy accounting requirements for leveraged leases and effectively grandfathers in that guidance. If a leveraged lease is modified after the effective date of ASC 842, it would be accounted for as a new lease.

A lease is a leveraged lease if it has all of the following characteristics:

• It meets the criteria to be classified as a direct financing lease.
• It involves at least three parties, including a long-term creditor.
• The financing provided by the creditor is nonrecourse with respect to the lessor’s general credit.
• The lessor’s net investment declines during the early years and rises during the later years.

Build-to-suit lease arrangements

ASC 842 supersedes the guidance in ASC 840 on build-to-suit arrangements. Under ASC 842, the accounting for a build-to-suit arrangement depends on whether the lessee controls the underlying asset during the construction period.

A lessee is considered the owner of an asset during the construction period if the lessee has substantially all of the construction period risks. There are certain automatic indicators of ownership, which have historically caused a number of lessees to be deemed owners of assets during the construction period.

Related-party leases

Entities should account for related-party leasing arrangements on the basis of the legally enforceable terms and conditions of the lease rather than the substance of the arrangement.

ASU 2023-01 allows private companies, as well as not-for-profit entities that are not conduit bond obligors, to elect a practical expedient in which the written terms and conditions of the arrangement are used to determine whether a lease exists and the subsequent accounting for the lease.

Entities should account for related-party leasing arrangements on the basis of the substance of the contract.

Reassessment (identifying a lease)

An entity should only reassess whether the contract is or contains a lease if the terms and conditions of the contract are changed.

An entity should only reassess whether an arrangement is or contains a lease if any of the following occur:

• Change in contractual terms.
• Renewal or extension (excluding a modification).
• Dependency on specific PP&E.
• Physical change to PP&E.

Reassessment (lessee measurement)

Upon a reassessment event, a lessee should remeasure its ROU asset and lease liability on its balance sheet. A lessee should use the discount rate that applies as of the date of the reassessment event to remeasure its ROU asset and lease liability.

A lessee should not remeasure a capital lease liability during the lease term unless the lease is modified. If the lease is modified and remeasured, the remeasurement should be based on the discount rate that was used at lease inception (i.e., the discount rate should not be updated).

Lease modifications

The lease modification guidance is more extensive under ASC 842, and the two-step model from ASC 840 is not carried forward. The changes are primarily related to aligning the modification guidance with the guidance in ASC 606.

A modification of a lease should be accounted for as a new lease if the modification would have resulted in a different lease classification had the changed terms been in effect at lease inception. A lease modification does not include renewals or extensions of the lease if such renewals or extensions were already included in the lease term.

Initial direct costs

Initial direct costs include only those costs that are incremental to the arrangement and that would not have been incurred if the lease had not been obtained.

In addition to costs that are incremental to the arrangement and that would not have been incurred if the lease had not been obtained, initial direct costs include costs directly related to the following activities:

• Evaluating the prospective lessee’s financial condition.
• Evaluating and recording guarantees, collateral, and other security arrangements.
• Negotiating lease terms.
• Preparing and processing lease documents.
• Closing the transaction.

Impairments

Operating leases are subject to the impairment guidance in ASC 360.

Operating leases are subject to the guidance in ASC 420 on exit and disposal activities.

Statement of cash flows (lessor)

A lessor must classify cash received from leases in the operating activities section of its statement of cash flows.2

ASC 840 does not include guidance on the classification of cash received from leases in a lessor’s statement of cash flows.

Disclosures

An entity must disclose significantly more quantitative and qualitative information under ASC 842.

Lessees and lessors are subject to relatively limited disclosure requirements.