Lease Accounting Under ASC 842: What Changed and Why It Matters

The Problem ASC 842 Was Designed to Solve

Under the old standard ASC 840, operating leases were off-balance-sheet financing. A company could commit to paying $50 million in rent over ten years and none of that obligation appeared on its balance sheet. ASC 842 changed this — virtually all leases with terms greater than 12 months must now be recognised on the balance sheet.

Finance Lease vs Operating Lease

A lease is classified as a finance lease if it transfers ownership, includes a likely purchase option, covers the major part of the asset's useful life, or the present value of payments equals substantially all of the asset's fair value. Otherwise it is an operating lease.

Right-of-Use Assets and Lease Liabilities

For both lease types, the lessee recognises a right-of-use (ROU) asset and a lease liability at commencement, measured at the present value of lease payments discounted at the rate implicit in the lease or the lessee's incremental borrowing rate.

The Critical Income Statement Difference

For a finance lease, the lessee amortises the ROU asset separately and recognises interest expense on the lease liability — front-loading total expense. For an operating lease, the lessee recognises a single straight-line lease expense. The balance sheets look similar; the income statements are completely different.