ASC 842 Summary: Key Principles of Lease Accounting

The Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) 842, Leases, to govern how entities account for lease agreements. Its primary goal was to increase the transparency of a company’s financial obligations. By requiring most leases to be recognized on the balance sheet, the standard provides investors and other stakeholders with a more complete picture of a company’s financial health. ASC 842 replaced the previous guidance, ASC 840, under which many operating leases were kept off the balance sheet, making it difficult to assess a company’s full leasing commitments. The standard was implemented for public companies for fiscal years beginning after December 15, 2018, and for private companies and nonprofits for fiscal years beginning after December 15, 2021.

The Core Principle and Scope of ASC 842

The foundational change from ASC 842 is the requirement for lessees to recognize a right-of-use (ROU) asset and a corresponding lease liability for nearly all leases. The ROU asset represents the lessee’s right to use the leased item for the lease term, while the lease liability represents the obligation to make lease payments. This on-balance-sheet recognition impacts a company’s reported assets and liabilities, which can alter key financial ratios that investors and lenders use to evaluate a company’s performance and risk profile.

The guidance in ASC 842 applies to all entities, including public, private, and not-for-profit organizations that enter into lease agreements. It covers leases for tangible assets such as real estate, vehicles, and equipment. However, the standard explicitly excludes certain types of leases from its scope, including those for intangible assets, non-regenerative resources like oil and gas, biological assets, inventory, and assets under construction.

Identifying and Classifying Leases

An entity must first determine if a contract is, or contains, a lease. ASC 842 defines a lease as a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. This definition hinges on two criteria: the existence of an identified asset and the right to control the use of that asset. An asset is identified by being explicitly stated in the contract or implicitly specified when it is made available for use.

The concept of “control” is central to the lease definition. A company has the right to control an asset if it has both the right to obtain substantially all of the economic benefits from the use of the asset and the right to direct its use. For example, if a company contracts for a specific data server that it operates and from which it receives all output, it likely has a lease. If the vendor can substitute the server at its discretion, a lease may not exist.

Once a contract is identified as a lease, the lessee must classify it as either a finance lease or an operating lease. This classification determines the subsequent accounting treatment. A lease is classified as a finance lease if it meets any one of five specific criteria. If a lease does not meet any of these criteria, it is classified as an operating lease. The five criteria for a finance lease are:

• The lease transfers ownership of the asset to the lessee by the end of the lease term.
• The lease grants the lessee an option to purchase the asset that the lessee is reasonably certain to exercise.
• The lease term is for the major part of the remaining economic life of the underlying asset.
• The present value of the sum of the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
• The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

Initial Measurement of Lease Assets and Liabilities

After classifying a lease, the next step is the initial measurement of the lease liability and the ROU asset. The lease liability is the present value of the future lease payments to be made over the lease term. This calculation is the same regardless of whether the lease is a finance or an operating lease.

The “lease payments” included in this calculation are specifically defined. They encompass fixed payments, less any lease incentives, and variable lease payments that depend on an index or a rate. Also included are the exercise price of a purchase option if the lessee is reasonably certain to exercise it, and penalties for terminating the lease if the lease term reflects that choice.

Determining the appropriate discount rate to calculate the present value is an important judgment. The preferred rate is the rate implicit in the lease. If this rate cannot be readily determined, the lessee should use its incremental borrowing rate. This is the rate of interest it would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.

As a practical expedient, private companies can elect to use a risk-free rate, an option that can be applied by class of underlying asset. This simplifies the process, though the rate implicit in the lease must still be used if it is readily determinable. Once the lease liability is calculated, the ROU asset is determined. The ROU asset is measured by starting with the initial amount of the lease liability, increasing it by any initial direct costs and lease payments made before commencement, and reducing it by any lease incentives received.

Subsequent Accounting and Financial Statement Presentation

Following initial recognition, the accounting for a lease diverges based on its classification. This impacts how expenses are recognized on the income statement and how cash flows are presented. For a finance lease, the accounting is similar to that of a purchased asset with debt financing. The ROU asset is amortized, typically on a straight-line basis, over the shorter of the lease term or the useful life of the asset. Concurrently, the lease liability is accreted using the effective interest method, with the resulting interest expense also recorded on the income statement, creating two separate expenses.

In contrast, for an operating lease, the lessee recognizes a single, combined lease expense. This lease expense is calculated on a straight-line basis over the lease term, allocating the total cost of the lease evenly to each period. The ROU asset is amortized in a way that the single lease expense is achieved.

The presentation on the statement of cash flows also differs. For a finance lease, the portion of the lease payment representing interest is classified within operating activities, while the principal repayment is classified within financing activities. For an operating lease, the entire lease payment is classified within operating activities.

Key Disclosures and Practical Expedients

ASC 842 mandates extensive disclosures to provide financial statement users with an understanding of an entity’s leasing activities. These disclosures are both qualitative and quantitative. Qualitative disclosures require companies to provide a general description of their leases, including information about variable lease payments, options to extend or terminate leases, and significant judgments made in applying the standard.

The quantitative disclosure requirements are detailed. Companies must disclose a maturity analysis for their lease liabilities, showing the undiscounted cash flows on an annual basis for the first five years and a total for the remaining years. Other required quantitative disclosures include the total lease cost, weighted-average remaining lease term, and weighted-average discount rate for both finance and operating leases.

To ease the burden of implementation, the standard offers several practical expedients. One is the short-term lease exemption, which allows a company to elect not to recognize an ROU asset or lease liability for leases with a term of 12 months or less that do not contain a purchase option the lessee is reasonably certain to exercise. Lease payments for these are recognized as an expense on a straight-line basis.

Another expedient allows entities to choose not to separate lease components from non-lease components (e.g., maintenance services). Instead, they can account for the combined component as a single lease component. This simplifies accounting but results in a higher ROU asset and lease liability.