ASC 842 is an accounting standard issued by the Financial Accounting Standards Board (FASB) that governs the accounting treatment for leases. It requires companies to recognize lease assets and liabilities on their balance sheets for almost all leases, including operating leases, previously only disclosed in footnotes.
The purpose of ASC 842 is to increase disclosure and visibility into the leasing obligations of both public and private organizations. Where previously most leases were not included on the balance sheet, the new ASC 842 lease accounting standard requires companies to report right-of-use (ROU) assets and liabilities for almost all leases.
These changes to financial statements make it easier for investors, vendors, government agencies, and business stakeholders to (1) see a company’s exposure to risk and true financial position, and (2) make comparisons between organizations.
The lease accounting standard ASC 842, replaces the lease accounting standard ASC 840.
Given the high cost of leases and their historical lack of representation on the balance sheet, the introduction of ASC 842 provides transparency into organizations’ lease liabilities.
Before ASC 842, operating leases were not included on the balance sheet, which neglected to provide a full picture of cash flows from leases. This meant companies and investors were unable to identify how much debt was carried within a business’ lease obligations.
The new lease accounting standard requires organizations to include operating leases and financial leases on the balance sheet, which increases visibility into leasing costs and arrangements. This ensures an accurate depiction of company financials.
In addition, ASC 842 closely aligns with the new international lease accounting standard IFRS 16, especially in the way a lease is defined. This makes financial reporting more consistent for organizations with both U.S. and international lease assets.
For more differences between the new standards, take a look at our IFRS & FASB Lease Accounting Changespage for a quick reference to all of the improvements.
Since FASB was issued ASC 842 in 2016, there have been numerous updates, such as:
Under the previous guidance, ASC 840, leases were labeled capital or operating leases. However, their labels were changed to finance and operating leases under ASC 842.
The criteria defining a finance lease is as noted under the guidance in 842-10-25-2:
If none of the criteria applies, then the lease would be considered an operating lease.
Accounting for both the finance lease and operating lease are similar under ASC 842, unlike ASC 840. The new standard now requires both leases to recognize both the lease liability and the right of use asset on the balance sheet unless the lease is considered a short-term lease (12 months or less).
Leasehold improvements are modifications a lessee makes to leased property to suit their business needs, such as installing fixtures or remodeling space. Under ASC 842, these improvements could be tracked separately from the right‑of‑use (ROU) asset and lease liability. thus when the improvements are funded by an incentive from the landlord, they do affect the ASC 842 accounting in different ways, commonly by reducing the initial ROU Asset if incentive is received in advance, or applying it as a payment credit if it will be received in a future month, leasehold improvements are amortized over the shorter of the improvement’s useful life or the lease term. This ensures the expense recognition matches the period the lessee benefits from the improvement. Organizations should track these costs independently for accurate financial reporting and compliance.
Lessor accounting has not had any significant changes under ASC 842. Similar to ASC 840, lessors still need to determine the type of lease to record, which will be either an operating lease, sales type lease or a direct financing lease.
Under a sales type lease, the lessor is assumed to be selling a product to the lessee, which calls for the recognition of a profit or loss on the sale. For the lessor to classify the lease as a sales back lease, the lease must meet any of the criteria, noted within 842-10-25-2 (provided above) at lease commencement.
Further, when none of the criteria in 842-10-25-2 are met, a lessor shall classify the lease as either a direct financing lease or an operating lease as noted within 842-10-25-3. The following criteria within the standard are as such:
If both of the following criteria are met, the lessor should classify the lease as an operating lease:
Otherwise, the lessor is to classify the lease as a direct financing lease.
| Aspect | ASC 840 (Legacy Standard) | ASC 842 (New Standard) | IFRS 16 |
| Balance Sheet Impact | Operating leases were off-balance sheet (expensed over time). | Both operating and finance leases are recognized on-balance sheet. (except for short-term leases) | All leases (except short-term/low-value) are on-balance sheet. |
| Lease Classification | Two types: Operating Lease, Capital Lease. | Two types: Operating Lease, Finance Lease. | Single lessee model — no classification; all treated as finance. |
| Lessor Accounting | Aligned with lessee classification; little change under 842. | Lessor model largely unchanged from ASC 840.t | Lessor model follows IFRS 15 (Revenue Recognition Standard). |
| Right-of-Use (ROU) Asset | Not recognized for operating leases. | ROU Asset recognized for both lease types (except for short-term leases). | ROU Asset recognized for nearly all leases. |
| Lease Liability | Only capital leases recognized a liability. | Liability recognized for all leases over 12 months. (Finance Lease Liabilities are considered Debt, while Operating ones are not) | Same as ASC 842 but applies to more leases due to single model. (Considered as Debt) |
| Income Statement Impact | Operating lease: Straight-line rent expense. Capital lease: amortization + interest. | Operating lease: Single lease expense. Finance lease: amortization + interest. | All leases: Amortization of ROU asset + interest expense. |
| Cash Flow Statement (Indirect Method) | Operating lease payments in operating activities. | Operating lease payments in operating activities. Finance lease payments in financing activities (principal portion). | All principal payments in financing activities. Interest varies by policy. |
| Scope | US GAAP only. | US GAAP only. | International standard (used globally). |
Under ASC 842, almost all leases must be represented on the balance sheet with a liability and an ROU asset. ASC 840 capital leases and ASC 842 finance leases are substantially the same. Both are capitalized on the balance sheet, and the method for doing so is similar under both standards. Discover how the new ASC 842 standard impacts the balance sheet.
Businesses can elect practical expedients to apply the accounting guidance more easily. Depending on the type of practical expedient, they can be elected by lease, class of asset or as an accounting policy. Examples of practical expedients include:
The disclosure requirements for ASC 842 are quantitative and qualitative. Under ASC 842, a lessee must disclose information about the nature of its leases and lease terms and conditions. This includes general descriptions of leases and various details regarding terms and conditions, such as the basis that variable lease payments are determined.
ASC 842 affects how lease payments appear on the statement of cash flows when using the indirect method. For finance leases, the principal portion of payments is presented as a financing activity, while the interest portion appears in operating activities. For operating leases, the entire payment is typically classified as an operating activity. This distinction impacts key performance metrics, such as operating cash flow. Accurate classification is critical to remain compliant and ensure financial statements reflect the economic substance of lease agreements.
Previously, only capital leases — leases that are essentially purchase agreements — needed to be recorded on the balance sheet. But under ASC 842, most leases except for short-term leases must also be included on the balance sheet.
In addition, FASB has changed the treatment of all leases to be intangible assets. This changes the terminology for capital leases, or leases that represent a purchase agreement. These leases are now called finance leases.
This means companies must report ROU assets and lease liabilities for operating leases as well as for finance (capital) leases under ASC 842. So now IT and office equipment, vehicles, construction equipment, and other leased assets must appear on the balance sheet along with real estate leases.
All the leases recorded under ASC 842 will now be part of the total reported assets and liabilities on an organization’s balance sheet — significantly changing the company’s financial statements.
A lease is defined as a contract or an element of a contract that conveys the right of use (ROU) of a physically distinct identified asset for a specified period of time in exchange for payment.
The identified asset can be property, plant, equipment, or other tangible assets. The period of time can be described in terms of the amount of use for the identified asset, such as the number of production units a piece of equipment will be used to produce, rather than in terms of time per se.
Note: ASC 842 does not include assets that are covered in other accounting standards:
Besides renaming capital leases “finance leases”, ASC 842 added a fifth lease classification question (“Is the asset so specialized that it is only useful to the lessee?”) to the test that determines whether a lease is a finance lease or an operating lease.
Essentially, this question says that after the asset is returned to the lessor, if the asset will have no value to anyone else without a major overhaul by the lessor, then the lease would be classified as a finance lease.
Under ASC 842, there are two types of leases for lessees: finance leases and operating leases. Finance leases are treated similarly to asset purchases, with separate recognition of interest and amortization. Operating leases, while still recognized on the balance sheet, result in a single straight-line lease expense on the income statement.
In addition, ASC 842 removed the so-called bright lines for the lease classification test. Previously these percentages were used to indicate what constitutes a “major part” of economic life (75%) or “substantially all” of the fair market value (90%); now these percentages are considered guidelines and you can elect whatever percentage you choose to use.
Although almost all leases must be capitalized on the balance sheet under ASC 842, it is still necessary to classify them as either a finance lease (previously capital) or an operating lease. That’s because finance leases and operating leases are measured differently.
The lease classification test determines whether a leased asset is essentially an alternative method of financing the purchase of an asset, or if the majority of the life and/or value of the underlying asset is controlled by the lessee; if so, it must be classified as a finance lease. Otherwise, the lease must be classified as an operating lease.
IFRS 16 includes a threshold under which leases can be considered “low value” and do not have to be capitalized on the balance sheet. However, FASB has not specified a low-value threshold for excluding leases from the balance sheet under ASC 842. If this is an issue for your organization, you can discuss it with your auditors to determine if you can use a materiality threshold.
Lease liability represents the current value of minimum future lease payments. To calculate it, you need to make assumptions about:
The discount rate to use for the calculation is either the rate implicit in the lease (if known) or your organization’s incremental borrowing rate (IBR). Privately-held firms also have the option to use a risk-free rate.
Keep in mind that the assumptions you make about lease options at the beginning of the lease often change over time. If during the term of a lease you change your mind about whether you are likely to exercise any lease options, you will need to remeasure both your lease liability and your ROU asset.
The ROU asset is calculated as the lease liability, plus or minus these adjustments:
Over the life of the lease, the ROU is amortized linearly. All of the assets and liabilities that adjust the ROU asset are reclassed from the balance sheet and included as one number to show the total leased asset.
Previously, because operating leases were not on the balance sheet, embedded leases had little impact on the income statement since the expense was usually being straight-lined. But now that all leases must be capitalized on the balance sheet, you need to:
Identifying embedded leases and their components is a complex task that takes time, judgment, experience, and consistency. It is another area where you might want to enlist the help and guidance of an accounting advisor.
Preparing for ASC 842 is a time-consuming, comprehensive effort that expands further than the accounting and finance department. It requires cross-departmental collaboration between IT, legal, procurement, etc.
In fact, since the introduction of the new standard, impacted private companies have been slow to make the transition. In July 2021, The Visual Lease Data Institute (VLDI) reported 75% of surveyed private companies were not yet fully compliant with ASC 842. In addition, 40% said they were underconfident in their ability to comply with the new lease accounting standard because they didn’t have all the necessary lease data gathered.
As of August 2022, The VLDI reported that while nearly all private companies (98%) have started the transition to ASC 842, one-third (33%) are still not fully prepared to implement the new standard.
Businesses are under massive pressure as they attempt to prepare for their initial reporting period under the new lease accounting standard.
The steps and milestones to ensure a successful transition to the new accounting standard are:
A business signs a 3-year lease for office space, agreeing to pay $12,000 at the end of each year. Under ASC 842, the business must record both a Right-of-Use (ROU) asset and a lease liability on its balance sheet for the present value of these payments.
Using a 5% discount rate, the total lease liability is calculated to be approximately $32,679. On the start date of the lease, the business records an ROU asset and a lease liability for this amount. Each year, the business pays $12,000, which is split between interest expense (starting at $1,634 in year one) and a reduction of the lease liability.
At the same time, the ROU asset is amortized evenly over the 3-year term (assuming a finance lease, otherwise the ROU amortization is a plug number as the difference between the Single Lease Expense and the Interest), resulting in an annual amortization expense of $10,893.
This approach ensures that the lease appears on the balance sheet and impacts both the income statement (through interest and amortization expenses) and the cash flow statement (operating activities), providing a more transparent view of leasing obligations compared to the previous ASC 840 rules.
Despite the clear objectives of ASC 842—to increase transparency and comparability in lease accounting—many organizations encounter challenges during implementation and ongoing compliance. Below are some of the most common pitfalls:
A significant challenge arises when companies fail to identify all contracts that meet the definition of a lease under ASC 842. Leases can be embedded in service or supply contracts, and overlooking these can lead to material misstatements.
ASC 842 distinguishes between finance leases and operating leases, each with different accounting treatments. Misclassifying leases—often due to misunderstanding classification criteria—can affect both the balance sheet and income statement.
Selecting the appropriate incremental borrowing rate (IBR) or using the risk-free rate (if permitted) is critical in calculating lease liabilities. Many companies use a generic or outdated rate, resulting in incorrect liability and asset measurements.
Companies need to update their ASC 840 processes to reflect the new requirements of ASC 842. Common pitfalls include:
Manual tracking and spreadsheets
Relying on spreadsheets for lease tracking is risky and inefficient. Manual processes are prone to errors, lack audit trails, and can’t scale with growing lease portfolios—especially under ASC 842’s expanded disclosure requirements.
Neglecting ongoing lease modifications
ASC 842 requires reassessment and remeasurement of leases when certain events occur (e.g., lease extensions, terminations, or payment changes). Failure to monitor and account for these modifications in a timely manner can lead to noncompliance.
Underestimating resource needs
Many companies underestimate the time, expertise, and system requirements necessary for implementation. This often leads to rushed decisions, incomplete data gathering, and compliance gaps.
Lack of internal controls and documentation
Strong internal controls and consistent documentation are essential for accurate lease accounting and audit readiness. Weak documentation around judgments (e.g., lease term assumptions, renewal options) can create issues during audits.
According to data from The VLDI, 71% of private companies believe ASC 842 presents an opportunity for their business.
The new lease accounting standards encourage organizations to adopt a centralized view of their lease portfolio, providing them with an opportunity to prioritize a proper lease management strategy. In turn, this provides them with much of the information they require to remain adaptable in a post-pandemic world.
Using a centralized system of record for leases provides companies with the ability to quickly and easily access crucial terms and clauses, such as the ability to exit, extend or change a lease.
With this newfound visibility, companies can respond to unforeseen circumstances strategically, such as a retailer needing to shutter brick-and-mortar locations or exercise an exclusivity or force majeure clause to protect the future of its business.
While some organizations manage and report on their leases using Excel, research has repeatedly shown that 90% of spreadsheets contain errors with 50% of processes enabled through those spreadsheets having “material defects”.
ASC 842 requires lease obligations to be captured on the balance sheet. The calculations that are involved to stay compliant with ASC 842 are extremely susceptible to error – particularly if done without automation.
Lease accounting software assists with ASC 842 compliance by automating calculations and financial reports. It enables you to ensure reliable data – and provides transparency into the math behind the calculations.
Without automated calculations or processes around lease management, you may run into issues related to human error or lack the ability to back up your calculations.
ASC 842 is the new lease accounting standard issued by the Financial Accounting Standards Board (FASB) to improve transparency in lease accounting. It replaces the previous standard, ASC 840, and significantly changes how leases are recorded by lessees and lessors. The main goal of ASC 842 is to bring most leases onto the balance sheet, requiring lessees to recognize both a right-of-use (ROU) asset and a lease liability for operating leases. This is a shift from the previous model under ASC 840, where operating leases were only disclosed in footnotes and not recorded on the balance sheet. ASC 842 affects both lessees and lessors, and introduces new classification and disclosure requirements for most all lease agreements.
ASC 842 applies to both public and private entities that prepare financial statements in accordance with Generally Accepted Accounting Principles (GAAP) in the United States. Public companies have been required to adopt ASC 842 since fiscal years beginning after December 15, 2018, while private companies had until December 15, 2021, to implement the standard. The standard is mandatory for any entity that enters into lease agreements, including both lessees and lessors.
ASC 842 introduces several important requirements for lease accounting:
The effective date of ASC 842 depends on the type of entity:
Private Companies: For fiscal years beginning after December 15, 2021.
The standard applies to all leases entered into after the effective date, and companies are required to adopt the new lease accounting rules by the first day of the fiscal year.
Under ASC 842, lessees are categorized based on how their leases are classified—either as an operating lessee or a finance lessee—depending on whether the lease meets specific criteria that determine the accounting treatment on the balance sheet and income statement.
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