ASC 842: Everything accountants need to know

Lease accounting went through a major transformation in recent years with the introduction of ASC 842, the Financial Accounting Standards Board's (FASB) current lease accounting standard. 

This new guidance brings most leases onto the balance sheet for greater financial transparency and consistency. Previously, companies didn’t need to report many leases, particularly operating leases, on the balance sheet formally. 

ASC 842 impacts lessees and lessors alike, introducing new rules for lease classification, measurement, and disclosure. Businesses, accounting professionals, and auditors have a duty to understand ASC 842 so they can maintain compliance and transparency in their finances and present a clear picture of financial commitments to stakeholders. 

To help you succeed, we’re going to break down the standard’s key components, effective dates, and how you and your accounting team can simplify compliance with the right tools. 

What is ASC 842?

ASC 842, also known as Accounting Standards Codification 842, is a set of lease accounting rules issued by the FASB. It provides guidelines for how businesses should recognize, measure, and disclose leases in their financial statements. ASC 842 replaces the previous standard, ASC 840, and introduces significant changes to lease accounting practices. 

What is a lease under ASC 842?

Under ASC 842, a lease is an agreement where one party (the lessee) gets the right to use a specific asset—like a building or equipment—for a set period in exchange for payment. To count as a lease, two things need to happen:

1. The lessee must have the right to benefit from using the asset (e.g., earning money or saving costs).
2. The lessee must have control over how the asset is used during the lease period.

The asset has to be clearly identified in the agreement, and the lessor, who owns the asset, can’t switch it out for something else without the lessee's approval.

The biggest change from ASC 840 to ASC 842 is that organizations must now include most leases on the company’s balance sheet, making it easier for people to understand a business’s financial commitments. 

ASC 842 effective dates 

The effective dates of ASC 842 vary based on the type of organization. 

1. Public entities — January 1, 2019: For public business entities, employee benefit plans that file with the SEC, and certain not-for-profits, ASC 842 became effective for fiscal years beginning after December 15, 2018. This means the standard has been in use for reporting periods since January 1, 2019.
2. Non-public entities — January 1, 2022:  For private companies and not-for-profits that do not meet public entity criteria, the standard was effective for fiscal years starting after December 15, 2021. 
3. Transition periods: Early adoption of ASC 842 was permitted for all entities, and many chose to implement it alongside ASC 606 (Revenue Recognition). Entities transitioning to the standard must apply the modified retrospective approach, requiring adjustments to prior periods presented in the financial statements. 
   

Importance of ASC 842

ASC 842 is important for accountants and businesses because it brings transparency and improved financial reporting for lease agreements. 

By requiring organizations to recognize most leases on their balance sheets, ASC 842 provides a more accurate depiction of a company's financial obligations and commitments. This increased visibility enhances the comparability and consistency of financial statements, benefiting investors, creditors, and other stakeholders.

How does ASC 842 work?

ASC 842 simplifies lease accounting by introducing a dual approach for lease classification: finance leases and operating leases. Finance leases are recorded on the balance sheet as assets and liabilities, while operating leases are treated as rental agreements. 

Accountants must assess lease agreements, determine their classification, measure assets and liabilities, allocate expenses, and provide detailed disclosures according to ASC 842. 

Scope and applicability of ASC 842

ASC 842 has a broad scope and applies to most lease arrangements involving tangible assets. 

Previously off-balance-sheet operating leases now need to be recognized on the balance sheet. The standard covers leases of tangible assets like real estate, equipment, and vehicles. 

However, leases of intangible assets, such as software licenses and patents, fall outside the scope of ASC 842. Short-term leases with a term of 12 months or less are exempt from recognition and measurement requirements but still require disclosure.

ASC 842 provides guidance on recognizing and measuring leases accurately. It differentiates between finance leases and operating leases based on specific criteria. Finance leases are treated as purchases, resulting in the recognition of lease assets and liabilities on the balance sheet. 

Operating leases, although not recorded on the balance sheet, require disclosure of lease-related information. ASC 842 measures lease liabilities as the present value of lease payments, including fixed and variable payments, options to extend or terminate leases, and any penalties. 

Lease assets, on the other hand, take their initial measurement from the lease liability amount, adjusted for lease incentives, initial direct costs, and any lease payments made before the lease commencement date. These measurements and adjustments ensure an accurate representation of lease-related obligations and commitments in the financial statements.

Benefits of ASC 842

ASC 842 provides several benefits for accountants and businesses:

• Improved financial transparency: ASC 842 ensures companies accurately reflect lease obligations on the balance sheet, providing a more comprehensive view of a company's financial position.
• Enhanced decision-making: With more visibility into lease commitments, businesses can make better-informed decisions regarding lease renewals, expansions, and portfolio optimization.
• Streamlined compliance: ASC 842 helps organizations adhere to accounting standards, reducing the risk of non-compliance and associated penalties.
• Increased investor confidence: By aligning lease accounting practices across industries, ASC 842 promotes consistency and comparability, enhancing investor confidence and trust.

Challenges of ASC 842

While ASC 842 brings many advantages, it's important to consider potential challenges:

• Implementation complexity: Adopting ASC 842 may require significant effort and resources to gather lease data, establish new processes, and update accounting systems.
• Increased administrative burden: ASC 842 demands ongoing lease tracking, analysis, and disclosure, which can be time-consuming and resource-intensive for businesses with large lease portfolios.
• Financial impact: Depending on lease arrangements, recognizing leases on the balance sheet may affect financial ratios, key performance indicators, and compliance with debt covenants.

Dedicated accounting software like NetLease can significantly ease these challenges by automating complex lease tracking and reporting on a user-friendly interface. As a case in point, Mariani Premier Group centralized 600 leases across more than 20 acquired companies, saving one of its subsidiaries 208 hours per year and keeping its expansive operations compliant with ASC 842.

ASC 842 lease accounting for lessees

ASC 842 requires lessees to record most leases on the balance sheet. Under ASC 842, businesses have to show both the right to use an asset (called a right-of-use asset) and the obligation to make lease payments (called a "lease liability").

There are two types of leases that lessees have to account for: operating leases and finance leases. They are treated a little differently, so you need to know which category your lease falls into.

Operating lease accounting 

Operating leases are often short-term or involve assets you don’t plan to own, like office space or printers. These leases are now on the balance sheet under ASC 842, but they work differently from finance leases:

1. Right-of-use asset and lease liability: You record both on the balance sheet.
2. Lease expense: Instead of breaking it into interest and depreciation, you combine everything into one expense. This expense stays the same each period, which makes it easier to predict costs.
3. Cash flow: Payments are considered operating expenses, so they show up under operating activities in your cash flow statement.

This method keeps things straightforward for companies that lease equipment or property for regular business use.

Finance lease accounting 

Finance leases, on the other hand, are more like purchases. They usually apply when you lease an asset long-term or plan to own it eventually. Here’s how they work:

1. Right-of-use asset and lease liability: Just like operating leases, you record these on the balance sheet.
2. Expenses: Costs are split into two parts:some text
   • Interest expense: For the cost of borrowing (like a loan)
   • Depreciation: For the asset’s wear and tear over time
3. Cash flow: Payments show up in two places—interest payments under operating activities and principal payments under financing activities.

Finance leases give a clearer picture of the cost of owning the asset over time. This setup is great for businesses leasing assets that are critical to their operations and might become permanent investments.

ASC 842 lease accounting for lessors 

For lessors, ASC 842 doesn’t change as much as it does for lessees. However, it introduces new rules to improve transparency and align with the updated approach for lessees. 

As a lessor, you’ll need to classify each lease as one of three types: operating, sales-type, or direct finance. How you handle the accounting depends on which type it is.

Operating lease accounting 

Operating leases are straightforward for lessors because you keep the asset on your books. This happens when you expect to get the asset back at the end of the lease and it retains value.

1. Asset recognition: The leased asset stays on your balance sheet as property, plant, and equipment.
2. Income recognition: You recognize the lease payments as income over the lease term, typically on a straight-line basis.
3. Expenses: You keep recording depreciation on the leased asset because it’s still yours.

Operating leases are common for things like equipment rentals or office leases, where the lessor maintains ownership throughout and beyond the lease term.

Sales-type lease accounting 

Sales-type leases happen when the lease is essentially a sale. This usually occurs when the lessee is expected to use up most of the asset’s value or will likely buy it at the end of the lease.

1. Derecognize the asset: You remove the asset from your balance sheet and record a lease receivable (the amount owed by the lessee).
2. Profit or loss: If the asset’s fair value exceeds its carrying value, you record a profit at the start of the lease. Conversely, if it’s less, you might record a loss.
3. Interest income: Over time, you earn interest income from the lease payments, which you’ll record separately.

Sales-type leases are common in industries like vehicle leasing or high-value equipment sales where ownership is likely to transfer.

Direct finance lease accounting 

Direct finance leases are similar to sales-type leases but without an immediate profit or loss at the start of the lease. This type applies when you’re financing the asset for the lessee and expect to earn income primarily from interest over time.

1. Asset removal and lease receivable: Like a sales-type lease, the asset comes off your books, and you record a lease receivable.
2. Interest income: You earn and record interest income over the lease term based on the lessee’s payments.
3. Residual asset: You might still record a residual value for the asset if you expect it to retain some value after the lease ends.

Direct finance leases are common for long-term agreements where the lessor provides financing but doesn’t intend to sell the asset outright.

Sale-leaseback accounting under ASC 842

Sale-leaseback transactions occur when a company sells an asset (like a building or equipment) and then leases it back from the buyer. This arrangement allows businesses to free up cash while continuing to use the asset. ASC 842 has specific rules to make sure companies report these transactions accurately:

1. Sale assessment: For the "sale" part to be valid, the transaction has to meet the criteria for a sale under ASC 606 (Revenue Recognition). If it doesn’t, the transaction is a financing arrangement rather than a sale.
2. Right-of-use asset and lease liability: If the sale is valid, the seller records a lease liability and a right-of-use asset for the leaseback. The gain or loss from the sale is only recognized for the portion of the asset not retained under the leaseback.
3. Disclosures: The transaction must include clear details about the terms of the sale and the lease, including any fixed or variable payments and renewal options.

These rules are aimed at stopping companies from using sale-leasebacks to manipulate financial statements by hiding liabilities or inflating income.

Leveraged lease accounting under ASC 842

Leveraged leases, which involve a lessor, a lessee, and a third-party lender providing financing, were popular under ASC 840. However, ASC 842 eliminates the special accounting treatment for leveraged leases. 

1. No special treatment: Leveraged leases are now treated like other lease types—operating, sales-type, or direct finance—based on their characteristics. This means lessors can no longer defer certain income or expenses as they did under ASC 840. 
2. Existing leveraged leases: If a leveraged lease was already in place before adopting ASC 842, the old rules continue to apply. New leveraged leases must follow ASC 842's general lease classification guidelines. 

This change simplifies the accounting process and increases transparency, but it also reduces some of the benefits that leveraged leases offered to lessors under the previous standard.

Both sale-leaseback and leveraged lease accounting under ASC 842 close loopholes and give stakeholders a more accurate picture of a company’s financial health. 

How do you modify and reassess leases?

ASC 842 addresses lease modifications and the reassessment of lease arrangements during their term. Here's what you should know about making changes to existing leases:

• Lease modification accounting: When lease terms change, such as lease extensions, modifications to lease payments, or changes in lease scope, organizations need to reassess lease classification and adjust the lease liability and asset accordingly.
• Substantive vs. non-substantive modifications: The current rules under ASC 842 consider lease modifications that result in a change to the scope or lease term as substantive modifications that require reassessment. Non-substantive modifications, such as changes to lease payments due to index or rate changes, may not require reassessment.
• Reassessment of lease liabilities: Reassessment of lease arrangements may require organizations to re-assume the lease liability based on the updated lease terms and conditions.
• Lease asset adjustments: Businesses generally adjust the lease asset based on the revised lease liability amount and any changes in lease payments or lease terms.

ASC 842 disclosure requirements

ASC 842 introduces new presentation and disclosure requirements for lease arrangements in financial statements. Lease liabilities and right-of-use assets should be presented separately from other liabilities and assets on the balance sheet. 

Companies should systematically and consistently present lease expenses, typically as separate line items in the income statement or as footnotes. 

Additional mandated disclosures include significant judgments, assumptions, lease terms, discount rates, and any uncertainties or risks related to leases. The rules also require a maturity analysis of lease obligations categorized by years to provide an overview of future lease payments.

Impact of ASC 842 on financial statements and disclosures

ASC 842 has a significant impact on financial statements and disclosures. Here's how it affects various aspects of financial reporting:

• Balance sheet: ASC 842 brings lease assets and liabilities onto the balance sheet, resulting in increased total assets and liabilities and potentially impacting financial ratios and key performance indicators.
• Income statement: ASC 842 typically recognizes lease expenses on a straight-line basis over the lease term, replacing the previous operating lease expense recognition.
• Cash flow statement: ASC 842 affects the classification of cash flows related to lease payments, resulting in changes to the presentation of operating, financing, and investing activities.
• Enhanced disclosures: ASC 842 introduces new disclosure requirements, such as detailed information about lease arrangements, lease costs, discount rates, and maturity analysis, providing stakeholders with more transparency and insight into lease-related obligations.

Accounting under GASB 87 vs. GASB 96

GASB 87 and GASB 96 are standards issued by the Governmental Accounting Standards Board (GASB) that focus on lease and subscription-based IT agreements, respectively. While both aim to bring more transparency to financial reporting for governmental entities, they apply to different types of arrangements and have distinct accounting rules. 

Organizations managing leases or IT subscriptions in the public sector need to understand GASB 87 and GASB 96, as they complement ASC 842 with equivalent guidance tailored to governmental accounting needs.

GASB 87: Lease accounting

GASB 87 is the equivalent of ASC 842 for government entities and deals specifically with lease agreements. Its goal is to ensure that companies recognize leases as assets and liabilities on the balance sheet. Here’s how it works:

1. Lease definition: A lease is an agreement giving the right to use an asset for a specific period in exchange for payment.
2. Recognition: Governments must record a right-of-use asset (an intangible asset) and a lease liability for the present value of lease payments.
3. Scope: GASB 87 applies to leases of tangible assets like buildings, equipment, and vehicles. It does not cover short-term leases (12 months or less) or agreements involving intangible assets.

By putting lease obligations on the balance sheet, GASB 87 increases accountability and makes a government entity’s financial obligations more transparent.

GASB 96: Subscription-Based IT Agreements (SBITAs)

A SBITA is an agreement where a government entity pays to access IT software or services for a set period. GASB 96 focuses on subscription-based IT arrangements, such as software as a service (SaaS) or cloud-based software agreements. These are different from leases because they involve access to technology rather than ownership or use of a physical asset.

1. Recognition: Similar to GASB 87, governments must record a subscription asset (an intangible right-of-use asset) and a subscription liability for the present value of future payments.
2. Scope: GASB 96 applies to arrangements where the government does not own the underlying IT assets. It excludes perpetual software licenses and short-term agreements.

Frequently asked questions about ASC 842

Here you can find some quick-fire answers to common questions to help you navigate ASC 842’s requirements and keep your lease accounting accurate.

Is ASC 842 applicable to all types of leases?

ASC 842 applies to most leases, including real estate, equipment, vehicles, and other tangible assets. However, it excludes leases with a term of 12 months or fewer and leases of intangible assets.

Is ASC 842 part of GAAP?

ASC stands for Accounting Standards Codification, which is the comprehensive set of accounting standards used in the United States under Generally Accepted Accounting Principles (GAAP). ASC provides guidance on various accounting topics, including lease accounting (ASC 842), revenue recognition (ASC 606), and financial statement presentation. It ensures consistent and standardized accounting practices across different industries.

Who must comply with ASC 842?

ASC 842 applies to both lessees and lessors and requires lessees to recognize most leases on their balance sheets as right-of-use assets and lease liabilities, bringing more transparency to lease accounting.

Is ASC 842 mandatory?

Yes, ASC 842 is mandatory for entities that follow U.S. GAAP. Public companies had to adopt it starting in 2019, while private companies and nonprofits faced deadlines in 2022. The new rules are essential for legal compliance, promoting transparency by requiring companies to record most leases on the balance sheet. 

Is IFRS the same as ASC 842?

ASC 842 and IFRS 16 (the international lease standard) are similar but not identical. Both require companies to record leases on the balance sheet, but IFRS 16 doesn’t classify leases into operating and finance categories for lessees. Instead, IFRS 16 treats everything as a finance lease. This difference can affect how companies report lease expenses in financial statements. 

How do I record a lease under ASC 842?

To record a lease under ASC 842, you first classify it as either an operating lease or a finance lease. Then, calculate the lease liability (the present value of future payments) and the right-of-use asset (the lease liability plus adjustments). You must record both on the balance sheet, and the new rules recognize expenses differently depending on the lease type.

Meet ASC 842 requirements with the best lease accounting software

Navigating ASC 842 compliance can feel overwhelming, especially with the added complexity of tracking lease data, calculating liabilities, and ensuring accurate disclosures. 

That’s where Netgain's lease accounting solutions come in. Designed by Big 4 accountants with simplicity and precision in mind, NetLease automates lease accounting while keeping you compliant with ASC 842.

NetLease supports accounting teams by: 

• Eliminating manual calculations
• Managing lease classifications 
• Generating accurate journal entries
• Providing detailed reports that align with ASC 842 requirements

Whether you’re dealing with a few leases or a large portfolio, schedule a demo and see how NetLease helps you meet ASC 842 requirements effortlessly.