ASC 842 Guide

What is ASC 842?

ASC 842 is an accounting standard from FASB (Financial Accounting Standards Board) that changed how companies report leases on their financial statements.

The big change: Before ASC 842, many leases (called "operating leases") were invisible on the balance sheet. You'd just show the monthly rent as an expense. The actual obligation—all those future payments you owed—didn't appear anywhere.

ASC 842 changed that. Now, virtually all leases longer than 12 months must appear on your balance sheet as both an asset (your right to use the leased item) and a liability (your obligation to make payments).

Who Does ASC 842 Apply To?

• Public companies: Required since 2019
• Private companies: Required since 2022
• Nonprofits: Required since 2022
• Any entity using GAAP: If you prepare GAAP-compliant financial statements, ASC 842 applies

If you're a small business that only prepares tax returns and doesn't issue formal financial statements, you may not need full ASC 842 compliance. But if you have lenders, investors, or other stakeholders who expect GAAP financials, you need to follow these rules.

Key Concepts Explained

Right-of-Use (ROU) Asset

This represents your right to use the leased property or equipment over the lease term. Think of it as the value of having access to that asset. It goes on your balance sheet as an asset.

How it's calculated: Generally, the present value of all your future lease payments (plus any upfront costs you paid, minus any incentives you received from the landlord).

What happens to it: You amortize (gradually expense) the ROU asset over the lease term, similar to depreciating a piece of equipment.

Lease Liability

This is your obligation to make future lease payments. It's a liability on your balance sheet because you owe money in the future.

How it's calculated: The present value of your remaining lease payments.

What happens to it: Each time you make a payment, part goes toward the liability (reducing what you owe) and part goes toward interest expense. It works similar to a loan.

Present Value

Since you're promising to pay money in the future, we need to calculate what that future money is worth today. A dollar you'll pay 5 years from now is worth less than a dollar you pay today—that's the time value of money.

Discount rate: You need an interest rate to calculate present value. Ideally, use the rate implicit in the lease (if your landlord disclosed it). More commonly, you'll use your "incremental borrowing rate"—essentially, the rate you'd pay if you borrowed that amount of money from a bank for a similar term.

Operating vs. Finance Leases

Both types now go on the balance sheet, but they're accounted for slightly differently:

Operating Lease: You're essentially renting. Expense is recognized evenly over the lease term (straight-line). Most office and retail space leases fall here.

Finance Lease: You're essentially buying the asset over time. Expense is front-loaded (higher in early years, lower later). A lease is a finance lease if any of these are true:

• Ownership transfers to you at the end
• There's a bargain purchase option you're likely to use
• The lease term covers most of the asset's economic life
• The present value of payments is substantially all of the asset's fair value
• The asset is so specialized only you could use it

What Information Do You Need?

To properly account for a lease under ASC 842, you'll need:

• Lease term: Start date, end date, and any renewal options you're reasonably certain to exercise
• Payment schedule: Amount, frequency, and any escalation clauses
• Discount rate: Either the rate implicit in the lease or your incremental borrowing rate
• Lease classification: Operating or finance (based on the criteria above)
• Initial direct costs: Costs you paid to negotiate or arrange the lease
• Lease incentives: Any payments or allowances you received from the landlord

Impact on Your Financial Statements

Balance Sheet

You'll show new line items: Right-of-Use Assets and Lease Liabilities. This increases both your total assets and total liabilities.

Financial Ratios

Because you're adding assets and liabilities, ratios change:

• Debt-to-equity: Will increase (more liabilities)
• Asset turnover: Will decrease (more assets)
• Return on assets: Will decrease (more assets in the denominator)

If you have loan covenants based on these ratios, check with your lender—they may need to be adjusted.

Ongoing Journal Entries

Each period, you'll need to record:

• Amortization of the ROU asset
• Interest expense on the lease liability
• Reduction of lease liability when payments are made

Common Mistakes to Avoid

• Forgetting embedded leases: Some service contracts contain embedded leases (like a data center contract that gives you dedicated server space)
• Using the wrong discount rate: Make sure your incremental borrowing rate reflects current market conditions and your credit quality
• Ignoring renewal options: If you're "reasonably certain" to renew, include that period in your calculations
• Not updating for modifications: If lease terms change, you may need to remeasure
• Missing short-term lease exemption: Leases of 12 months or less can stay off the balance sheet

The Short-Term Lease Exception

Good news: if a lease is 12 months or less (including any renewal options you're likely to exercise), you can elect to keep it off the balance sheet. Just expense the payments as you go, like the old rules.

This election is made by asset class, not lease-by-lease. So if you elect it for vehicles, it applies to all your short-term vehicle leases.

Required Disclosures

In addition to the balance sheet presentation, ASC 842 requires detailed footnote disclosures including:

• Nature of your leasing activities
• Significant judgments you made (like determining discount rates)
• Maturity analysis showing future payment obligations by year
• Components of lease cost