Lease agreements significantly impact the financial landscape of businesses. Understanding ASC 842 is essential for accurate financial reporting and compliance. On February 25, 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases (Topic 842): (Source). It brought significant changes to lease accounting. Both public and private companies must now recognize virtually all leases on their balance sheets. 

This new standard affects businesses across all industries. It spans from healthcare and manufacturing to retail and transportation. This makes it crucial for CFOs, accountants, and financial teams to master its intricacies.

For example, related standards are essential for those managing operating or finance leases under ASC 842. These include ASC 805, which addresses business combinations. Another one is ASC 820, covering fair value measurement.

ASC 842 requires a deeper understanding of lease management. This includes operating or finance leases. Leases impact your financial statements, cash flow, and overall business strategy.

What is ASC 842?

ASC 842 is the lease accounting standard introduced by the Financial Accounting Standards Board (FASB). It aims to improve transparency and consistency in financial reporting for lease agreements. It replaced the earlier standard, ASC 840. Companies must recognize both operating and finance leases on their balance sheets, with few exceptions. 

The goal of ASC 842 is to provide investors and stakeholders with a clearer picture of a company’s lease obligations. It aims to enhance comparability across industries. This standard affects nearly all U.S. entities that enter into lease agreements. Therefore, it is essential for businesses to comply. They must accurately report their lease liabilities and right-of-use assets. 

By doing so, ASC 842 provides a more comprehensive view of a company’s financial health.

ASC 842 Lease Accounting Examples 

ASC 842 significantly changes how companies account for leases by requiring the recognition of right-of-use assets and lease liabilities. The accounting treatment varies depending on whether the lease is classified as an operating or finance lease. Below are some practical examples to illustrate how ASC 842 lease accounting works:

Example 1: Operating Lease
A company enters into a five-year office lease with monthly payments of $10,000. Under ASC 842, the company will recognize a right-of-use asset. It will also recognize a corresponding lease liability on the balance sheet. The lease expense will be straight-lined over the lease term.

Example 2: Finance Lease
A manufacturer signs a lease for equipment valued at $500,000 over a ten-year period. Since the lease transfers ownership by the end of the term, it is treated as a finance lease. The company will record the asset on the balance sheet and recognize both interest and amortization expenses.

Example 3: Short-Term Lease (Practical Expedient)
A business leases equipment for 11 months with no intention to renew. Under ASC 842’s practical expedient, this lease can be excluded from the balance sheet. Lease expenses are recognized in the income statement as incurred.

What is ASC 842 Summary?

ASC 842 is a lease accounting standard. It requires businesses to recognize lease assets and liabilities on their balance sheets. This applies to both operating and finance leases. 

It aims to enhance transparency. It provides more accurate reporting of lease obligations. These obligations were previously off-balance sheets for operating leases. 

The standard applies to companies across all industries. It helps investors and stakeholders better assess a company’s financial commitments. It also provides insight into a company's overall health.

Types of ASC 842 Lease Accounting

What is ASC 842 Summary

Under ASC 842, leases are classified into two main categories: operating leases and finance leases. The classification impacts how lease assets and liabilities are recognized and how expenses are reported on the income statement.

1. Operating Leases: These leases allow the lessee to use an asset without transferring ownership. Expenses are recognized evenly over the lease term.

2. Finance Leases: In this type, the lease effectively transfers ownership or contains terms like a purchase option. The lessee recognizes both interest and amortization expenses.

3. Short-Term Leases: Leases with terms of 12 months or less can qualify for a practical expedient. This qualification excludes them from balance sheet reporting.

What are the ASC 842 Journal Entries?

ASC 842 requires businesses to record journal entries to reflect the financial impact of their lease agreements accurately. Different journal entries will be made depending on the lease classification. It could be an operating or finance lease. These entries recognize the right-of-use asset and lease liability on the balance sheet. 

The lease payments and associated expenses are also handled differently under each lease type. Below is an overview of the key journal entries required under ASC 842:

For Operating Leases:

Debit: Right-of-Use (ROU) Asset

Credit: Lease Liability

As lease payments are made:

  • Debit: Lease Liability
  • Credit: Cash
  • Debit: Lease Expense
  • Credit: ROU Asset (amortization)

For Finance Leases:

Debit: Right-of-Use (ROU) Asset

Credit: Lease Liability

As lease payments are made:

  • Debit: Lease Liability (for principal payment)
  • Debit: Interest Expense
  • Credit: Cash
  • Debit: Amortization Expense (for ROU asset depreciation)
  • Credit: Right-of-Use Asset

ASC 842 Journal Entry for Operating Leases

Under ASC 842 lease accounting, journal entries for operating leases require the lessee to recognize both a right-of-use (ROU) asset. The lessee must also recognize a corresponding lease liability on the balance sheet. 

Unlike the previous standard, operating leases were primarily off-balance-sheet. However, ASC 842 mandates that these leases now be included in financial statements. 

Throughout the lease term, the lease liability decreases as payments are made while the right-of-use asset is amortized. The expenses are generally straight-lined, meaning the lease expense remains consistent over the lease period.

A typical set of ASC lease accounting journal entries for operating leases would look like this:

Initial recognition of the lease:

  • Debit: Right-of-Use Asset
  • Credit: Lease Liability

During the lease term, as payments are made:

  • Debit: Lease Liability
  • Credit: Cash
  • Debit: Lease Expense
  • Credit: Right-of-Use Asset (Amortization)

These entries help businesses comply with ASC 842 while accurately reporting the financial impact of their operating leases.

ASC 842 Journal Entry for Finance Leases

When dealing with finance leases under ASC 842, journal entries focus on recognizing lease assets on the balance sheet. They also focus on recognizing the liabilities related to the lease. The main difference between finance and operating leases is how expenses are recognized. 

Finance leases incur both interest and amortization expenses over the lease term, similar to a loan. Proper financial reporting requires recording an ASC 842 journal entry correctly. This is necessary for a lease classified as a finance lease.

Here is an example of how you would record a finance lease under ASC 842:

Initial recognition of the finance lease:

  • Debit: Right-of-Use Asset
  • Credit: Lease Liability

As lease payments are made:

  • Debit: Lease Liability (for principal portion)
  • Debit: Interest Expense (for interest portion)
  • Credit: Cash

Recognition of amortization for the right-of-use asset:

  • Debit: Amortization Expense
  • Credit: Right-of-Use Asset

This journal entry structure ensures that finance leases are properly reflected in financial statements. It maintains compliance with ASC 842. Stakeholders get a clearer picture of a company’s lease obligations.

Who Does ASC 842 Affect?

ASC 842 affects nearly all entities in the U.S. that engage in lease agreements, including both public and private companies. It applies across a wide range of industries, like construction, healthcare, manufacturing, retail, transportation, and more. 

This standard impacts businesses of all sizes. It requires them to recognize lease assets and liabilities on their balance sheets. Before, this was not required for operating leases. By enhancing transparency in financial reporting, ASC 842 has significant implications for companies, investors, and stakeholders alike.

Lease Accounting Updates:

ASC lease accounting was introduced in 2016. Since then, FASB has issued several updates to address various aspects of lease accounting. These updates aim to clarify guidance. They provide practical expedients and refine the standard. This helps ease the transition for companies and enhance the accuracy of financial reporting. 

ASU 2017-13: Amendments to SEC Paragraphs

This update provides amendments to SEC guidance. It aligns lease accounting with federal regulatory requirements. This ensures compliance.

ASU 2018-01: Land Easement Practical Expedient for Transition

Offers a practical expedient for entities with land easements. This allows them to avoid reassessing earlier lease arrangements during the transition to ASC 842.

ASU 2018-10: Codification Improvements

This document addresses minor corrections and clarifications to the standard. These changes guarantee consistent application of ASC 842 across different industries.

ASU 2018-11: Targeted Improvements

Introduces simplified transition methods and practical expedients to help entities more easily implement ASC 842.

ASU 2018-20: Narrow-Scope Improvements for Lessors

This document focuses on lessor accounting. It provides narrow-scope improvements. These improvements enhance the clarity of lease classification and presentation for lessors.

ASU 2019-01: Codification Improvements

This update makes additional technical corrections to lease accounting guidance. It addresses issues related to fair value. It also covers implicit rates.

ASU 2019-10: Effective Dates

Adjusts the effective dates for implementing ASC 842. This adjustment provides more time for certain entities to comply with the standard.

ASU 2020-02: Amendments to SEC Section on Effective Date

Further revisions are made. These changes refine the effective dates for ASC 842. These changes provide specific SEC registrants with additional flexibility for implementation.

ASU 2020-05: Effective Dates for Certain Entities

This grants an extension of the effective dates for non-public business entities. It allows them to defer the adoption of ASC 842.

ASU 2021-05: Lessors – Certain Leases with Variable Lease Agreements

It addresses specific challenges that lessors face. These challenges occur when dealing with variable lease payments. The aim is to ensure clearer guidance on accounting treatment.

ASU 2021-09: Discount Rate for Lessees That Are Not Public Business Entities

It offers a practical expedient. This allows non-public entities to use a risk-free discount rate. This approach simplifies lease liability calculations.

ASC 842 Practical Expedients

ASC 842 provides several practical expedients to help ease the transition for companies implementing the new lease accounting standards. These practical expedients allow businesses to simplify the adoption process without fully reassessing existing leases. 

The package of practical expedients allows entities to avoid reassessing whether contracts contain a lease. It also allows them to avoid reassessing lease classifications or initial direct costs for existing leases. 

Additionally, a specific expedient is available for land easements, permitting companies not to reassess the treatment of pre-existing land easements. These tools are designed to make compliance with ASC lease accounting more manageable. They are especially useful for companies with large volumes of lease contracts.

ASC 842: Financial Statement & Calculation Impacts

The introduction of ASC 842 brings significant changes to businesses' financial statements. It requires the recognition of lease-related assets and liabilities. Companies must now record a right-of-use asset. They must also record a corresponding lease liability for nearly all leases. This impacts both the balance sheet and income statement. 

For finance leases, businesses must recognize interest and amortization expenses, while operating leases need a straight-line lease expense. These changes impact key financial ratios, like debt-to-equity and return on assets, potentially influencing stakeholder perception and decision-making. 

In terms of calculations, determining the current value of lease payments is essential. Allocating these payments between interest and principal payments is also crucial. These steps are critical elements of compliance under ASC 842.

How Does ASC 842 Change the Balance Sheet?

ASC 842 fundamentally changes the balance sheet by requiring companies to recognize almost all leases as both assets and liabilities. 

Before, operating leases were typically off-balance-sheet, but under ASC 842, they are now recorded as right-of-use assets and lease liabilities. 
How Does ASC 842 Change the Balance Sheet

This change increases the total assets and liabilities on the balance sheet. It gives a more precise picture of a company’s financial obligations. For finance leases, both the asset and liability decrease over time as payments are made. Operating leases, on the other hand, show consistent lease expenses. 

As a result, key metrics like debt levels and leverage ratios are affected. This can affect lending decisions. It can also influence investor evaluations and regulatory compliance.

How to Calculate a Lease Liability Under ASC 842

To calculate a lease liability under ASC 842, the liability is based on the current value of future lease payments. The key factors required for this calculation include the lease term, the lease payments, and the discount rate. 

The formula used is the current value of future lease payments. These payments are discounted using the lessee’s incremental borrowing rate. They can also be discounted using the rate implicit in the lease, if known.

Formula:

Lease Liability = ( P / ( 1 + r ) n )

Where:

  • PPP = Lease payment
  • rrr = Discount rate (incremental borrowing rate or rate implicit in the lease)
  • nnn = Number of periods (lease term)

Let's calculate a lease liability based on the next example:

  • Monthly lease payment: $5,000
  • Lease term: 5 years (60 months)
  • Incremental borrowing rate: 5% annually (0.4167% monthly)

We'll calculate the current value of the monthly lease payments over 60 months using the formula above.

Based on the given data, the lease liability under ASC 842 is calculated to be approximately $264,954. This signifies the current value of the future lease payments over a five-year term with a 5% annual discount rate.

The Difference Between ASC 842 vs. IFRS 16

ASC 842 and IFRS 16 are both lease accounting standards, but they differ in their treatment of leases. Under ASC lease accounting, operating and finance leases are treated differently. Operating leases need straight-line expense recognition. Finance leases are treated similarly to capital leases. 

In contrast, IFRS 16 eliminates the distinction between operating and finance leases for lessees. It requires all leases to be recorded on the balance sheet. 

These differences impact how companies in different jurisdictions report their leases and manage compliance.

FeatureASC 842IFRS 16
Lease ClassificationTwo types: Operating and Finance LeasesSingle model: All leases on balance sheet
Lessee AccountingOperating leases: Straight-line expenseAll leases recognized as right-of-use assets and liabilities
Lessor AccountingNo major changes from ASC 840Largely similar to ASC 842
ExemptionsShort-term leases and low-value assetsShort-term leases and low-value assets
Impact on Financial RatiosLower for operating leases, more for finance leasesGreater impact as all leases are recognized

When Must ASC 842 be Adopted?

The adoption deadlines for ASC 842 vary depending on whether the company is public or private. Public companies had to adopt ASC lease accounting for fiscal years beginning after December 15, 2018. For private companies and not-for-profits, the standard was deferred, requiring adoption for fiscal years beginning after December 15, 2021. 

Businesses that have yet to adopt the standard should act quickly. They need to guarantee compliance. They must adjust their financial reporting processes properly.

Does ASC 842 Apply to Non-Public Companies?

ASC 842 applies to non-public companies, including private businesses and not-for-profit entities. While the adoption timeline was extended for non-public companies, they are still obligated to follow the standard. 

The adoption of ASC lease accounting will impact how non-public companies account for leases. It requires the recognition of right-of-use assets. Companies must also recognize lease liabilities on the balance sheet, akin to public companies.

Closing Note

ASC 842 has brought significant changes to lease accounting, impacting businesses of all sizes and industries. The standard requires leases to be recognized on the balance sheet. This enhances transparency. It provides stakeholders with a clearer view of a company’s financial obligations. Whether dealing with operating leases or finance leases, companies must understand ASC 842's complexities. They must stay compliant to keep precise financial reporting. Adopting the standard not only improves financial clarity but also helps businesses better manage their lease-related risks. For further insights into ASC topics, visit our comprehensive guide at NJCPA USA's Accounting Standards Codification.