What New Lease Accounting Rule Took Effect in the United States?

The Evolving Landscape of Lease Accounting in the United States

For many years, financial reporting of lease agreements in the United States allowed a significant portion of a company’s lease obligations to remain undisclosed on the balance sheet. This practice meant contractual commitments were often only visible in footnotes, making it challenging for stakeholders to fully assess a company’s true financial leverage. A new rule addressing these concerns took effect in the United States in 2019, fundamentally reshaping how companies report their leasing activities.

The New Lease Accounting Standard Explained

The Financial Accounting Standards Board (FASB) introduced Accounting Standards Codification (ASC) 842, “Leases.” ASC 842 aims to enhance transparency and comparability by requiring lessees to recognize most leases directly on their balance sheets. This provides a clearer picture of a company’s financial obligations and leased assets.

Under this standard, two terms are central: the “Right-of-Use (ROU) asset” and the “lease liability.” An ROU asset represents a lessee’s right to control an identified asset for a period. A lease liability is the lessee’s financial obligation to make lease payments, measured at their present value.

Nearly all leases now require the recognition of both an ROU asset and a corresponding lease liability for the lessee. This applies to a wide range of leased items, from real estate to equipment. An exception exists for short-term leases, defined as those with a lease term of 12 months or less and no purchase option reasonably certain to be exercised. Companies can elect not to recognize ROU assets and lease liabilities for these arrangements, instead expensing the lease payments on a straight-line basis.

Key Differences from Previous Rules

The shift from the previous standard, ASC 840, to ASC 842 significantly changed how leases are accounted for. Under ASC 840, many operating leases were “off-balance sheet,” obscuring a company’s full financial commitments.

ASC 842 mandates that operating leases, previously off-balance sheet, now require recording an ROU asset and a lease liability. While both operating and finance leases are now on the balance sheet, their subsequent accounting treatment differs.

Leases are now classified by lessees as either “finance leases” or “operating leases,” replacing the former “capital lease” designation. A lease is a finance lease if it meets any of five criteria: ownership transfers to the lessee, there is a purchase option reasonably certain to be exercised, the lease term represents a major part of the asset’s economic life (often 75% or more), the present value of lease payments covers substantially all of the asset’s fair value (often 90% or more), or the asset is so specialized it has no alternative use to the lessor after the lease term. If none of these criteria are met, the lease is an operating lease.

Accounting for finance leases generally results in a front-loaded expense pattern, with separate recognition of interest expense on the lease liability and straight-line amortization of the ROU asset. In contrast, operating leases under ASC 842 recognize a single, straight-line lease cost over the lease term. This is achieved by adjusting the ROU asset amortization each period to ensure the total lease expense remains consistent.

The lease liability is initially calculated as the present value of future lease payments. The ROU asset is measured at the lease liability amount, adjusted for initial direct costs, prepaid payments, or incentives. Subsequently, the lease liability decreases with payments and increases with interest accretion. The ROU asset is amortized over the lease term, with the method depending on lease classification.

The implementation of ASC 842 impacts a company’s financial statements. On the balance sheet, there is an increase in both assets (ROU assets) and liabilities (lease liabilities), reflecting previously off-balance sheet arrangements. The income statement reflects different expense patterns for finance versus operating leases. On the cash flow statement, payments for operating leases are generally operating cash outflows, while finance lease payments are split, with the principal portion as a financing activity and the interest portion as an operating activity.

Who is Affected and When

ASC 842 primarily impacts lessees. Effective dates for compliance were staggered by entity type.

For public companies, the standard became effective for fiscal years beginning after December 15, 2018, meaning many applied it starting January 1, 2019. For private companies and not-for-profit entities, the standard became effective for fiscal years beginning after December 15, 2021. Many private companies with a calendar year-end began applying ASC 842 on January 1, 2022.

How Companies Applied the New Standard

A common transition approach was the modified retrospective method. This allowed entities to apply the guidance either from the earliest period presented or at the effective date, without restating prior comparative periods.

The FASB provided several optional practical expedients to ease adoption. One widely used option was the “package of three” expedients, elected together. This package allowed companies to avoid reassessing whether existing contracts contained a lease or their classification, and not to reassess initial direct costs or land easements.

Companies could also elect to combine lease and non-lease components, simplifying allocation. Private companies could use a risk-free rate for discount rate calculations, applied by asset class. These expedients provided flexibility.

The standard introduced expanded qualitative and quantitative disclosure requirements in financial statement footnotes. These provide users with detailed information on leasing activities, including a general description of arrangements, significant judgments, and a maturity analysis of lease liabilities. Companies also disclose weighted-average discount rates, cash paid for lease liabilities, and information on variable lease payments and sublease income.