Differences Between ASC 840 and ASC 842: New 5th Test



George Azih:

Another difference is that you now have a fifth test. As accountants, we all know that there’s four tests under 842 to determine if a lease is capital or operating. And here at LeaseQuery we like to call the first two tests the strong form links, i.e., if the title transfers after the lease term, then it’s a strong form lease. Or if there’s a bargain purchase option, then it’s a strong form capital lease.

Why is that different? Because there’s two types of, as I said, two types of capital leases. Not really … once again, that’s how we like to distinguish between the two here, is the first two, if they pass the first two tests, then you would amortize it over the life of the asset. You amortize it over the life of the asset as if it’s owned. However, if it’s the other two, then you amortize it over the lesser of the lease term or the asset. So, that’s why you have a difference between capital leases, even within capital leases. So, the fourth test, bargain purchase option, like title transfers at lease end, the lease term test at 75%, that’s for a lease term, and the 90% test for present value of a minimum lease payment. Those are the four tests.

Now, under 842, you have a fifth test, i.e., if the lease is such … if it happened in such a specialized asset in nature that it provides no value to the lessor after the lease is over, then it’s also a capital, a finance lease. So if the asset is highly specialized and because of that high specialization, it has no value to lessor after the lease term, then it’s a capital lease. It’s a finance lease. Also the bright lines have been eliminated, right, so currently we have 75% for the lease term and 90% for the fair value, essentially those bright lines are now gone. So you no longer have the bright line test.

The challenge that you see here is that now companies say, okay, I’d like to take portfolio approach. If I look at, let’s say I have a fleet of vehicles and do I have to test those individually, rather than just testing the whole portfolio, I have a fleet. Now, I’ve been listening obviously to the boards and to the big four firms and what we’ve seen at the big four firms, what they are saying is, that approach is fine to take similar leases, similar assets that have similar start dates, similar end dates, similar payments and group them. However, they would need to obviously pass so like when you perform the test, they would either need to obviously fail or obviously pass. Although we shouldn’t use the expression fail or pass. But they need to be obviously finance leases or obviously operating leases because if it’s close then the law of averages is working out there. Some of them are failing, some of the assets are failing and some of the assets are financed and some of them are operating and their average, they are canceling each other out. If they are canceling each other out, then they’ll make you go back and actually bifurcate those tests on an asset by asset basis. So that’s something that we heard from boards, not from boards but the big four accounting firms stick as far as using the portfolio structure.