What Is Accounting Standards Codification 842?
Accounting Standards Codification 842 (ASC 842) is the current Accounting Standards governing how entities in the United States account for leases. Issued by the Financial Accounting Standards Board (FASB), ASC 842 represents a significant shift in Financial Reporting by requiring most leases, including what were previously classified as operating leases, to be recognized on a company's Balance Sheet. This standard aims to enhance transparency by providing a more complete picture of an organization's assets and liabilities arising from lease agreements. Under ASC 842, lessees (the parties leasing an asset) are required to recognize a Right-of-Use Asset and a corresponding Lease Liability for nearly all leases with a Lease Term greater than 12 months.
History and Origin
The evolution of lease accounting standards has been driven by a long-standing desire for greater transparency in financial statements, particularly regarding Off-Balance Sheet Financing. Prior to ASC 842, the previous standard, ASC 840 (formerly FAS 13), allowed many operating leases to be kept off the balance sheet, leading to concerns that significant financial obligations were not adequately disclosed to investors and other stakeholders.78 This practice made it challenging to assess a company's true financial position and compare companies with different leasing models.76, 77
To address these concerns and improve comparability, the FASB and the International Accounting Standards Board (IASB) embarked on a joint project to develop new lease accounting standards.74, 75 Although they began with a common goal, the two boards ultimately issued separate, though largely converged, standards: IFRS 16 (for international standards) and ASC 842 (for U.S. Generally Accepted Accounting Principles, or GAAP).71, 72, 73 The FASB issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), on February 25, 2016.68, 69, 70 This update fundamentally changed how lessees account for leases, making it mandatory to recognize lease assets and liabilities for most lease agreements on the balance sheet.67 Public companies were required to adopt ASC 842 for fiscal years beginning after December 15, 2018, while private companies and non-profit organizations had later effective dates, with a second delay granted due to the COVID-19 pandemic, making it effective for annual reporting periods beginning after December 15, 2021.63, 64, 65, 66
Key Takeaways
- ASC 842 mandates that most leases be recognized on a company's balance sheet as a Right-of-Use (ROU) asset and a corresponding lease liability.60, 61, 62
- This standard aims to increase transparency and provide a more accurate depiction of a company's financial obligations, reducing the impact of off-balance sheet financing.56, 57, 58, 59
- Leases are primarily classified as either Finance Lease or Operating Lease under ASC 842, with distinct accounting treatments impacting the income statement and cash flow statement.52, 53, 54, 55
- Companies must reassess certain lease components, such as the lease term and discount rate, throughout the life of the lease, requiring robust data management and analysis.50, 51
Formula and Calculation
Under ASC 842, the Lease Liability is measured as the Present Value of the remaining lease payments. The Right-of-Use (ROU) Asset is generally measured at the lease liability amount, adjusted for any initial direct costs, lease incentives received, and prepaid or accrued lease payments.48, 49
The present value calculation requires a Discount Rate. Lessees are required to use the rate implicit in the lease if it is readily determinable. If not, the lessee uses its incremental borrowing rate. Private companies have a practical expedient allowing them to use a risk-free rate for a period comparable to the lease term.44, 45, 46, 47
The formula for the lease liability, which forms the basis for the ROU asset, is:
Where:
- (\text{LP}_t) = Lease Payment in period (t)
- (n) = Total number of periods in the lease term
- (r) = Discount rate (rate implicit in the lease or incremental borrowing rate)
- (t) = Time period
Interpreting Accounting Standards Codification 842
Interpreting financial statements under ASC 842 requires understanding that nearly all leases now appear on the Balance Sheet, altering key financial ratios compared to prior periods.43 For instance, the recognition of Lease Liability will increase total liabilities and assets, which can impact leverage ratios like debt-to-equity and debt-to-assets.42 While the overall financial commitment may not have changed, its visibility has significantly increased.
Analysts and investors evaluating a company's financial health will now have a clearer view of its contractual obligations related to leased assets.40, 41 For Operating Lease arrangements, a single, straight-line lease expense is recognized in the Income Statement.39 For Finance Lease arrangements, both interest expense on the lease liability and amortization expense of the Right-of-Use Asset are recognized, typically resulting in higher expenses in the earlier years of the lease.38 This distinction in expense recognition is a key element in understanding a company's reported profitability.
Hypothetical Example
Consider "Tech Solutions Inc.," a company that leases office space for a five-year term with annual payments of $50,000, payable at the beginning of each year. The implicit rate in the lease is not readily determinable, so Tech Solutions Inc. uses its incremental borrowing rate of 5%.
Under ASC 842, Tech Solutions Inc. must calculate the Present Value of these lease payments to determine the initial Lease Liability and Right-of-Use Asset.
Year 1: $50,000 (payment made at beginning, so no discounting)
Year 2: $50,000 / = $47,619.05
Year 3: $50,000 / = $45,351.48
Year 4: $50,000 / = $43,191.88
Year 5: $50,000 / = $41,135.12
Total Present Value of Lease Payments = $50,000 + $47,619.05 + $45,351.48 + $43,191.88 + $41,135.12 = $227,297.53
At the commencement date, Tech Solutions Inc. would record a Right-of-Use Asset and a Lease Liability of $227,297.53 on its balance sheet. This new accounting treatment provides a clearer representation of the company's long-term obligations.
Practical Applications
ASC 842 has profound implications across various aspects of business and finance, particularly in Financial Reporting and analysis. Its core principle requires companies to record lease obligations on their Balance Sheet, significantly altering how financial statements are prepared and interpreted.37
In corporate finance, understanding ASC 842 is crucial for companies involved in significant leasing activities, such as airlines, retailers, and transportation firms.36 The standard impacts how these companies manage their lease portfolios, evaluate new lease agreements, and perform strategic financial planning.35 For example, the decision to lease versus buy an asset may be re-evaluated given the on-balance sheet recognition of lease liabilities.
For investors and analysts, ASC 842 provides enhanced visibility into a company's true leverage and financial commitments, which were previously obscured by Off-Balance Sheet Financing. This improved transparency allows for more accurate financial modeling and better comparability between companies, regardless of their lease structures.34 For a comprehensive guide on navigating these changes and their impact on financial reporting, resources from leading advisory firms like Deloitte offer detailed insights.33
Limitations and Criticisms
While Accounting Standards Codification 842 aims to improve transparency, its implementation has presented certain challenges and criticisms. One significant concern has been the complexity and cost associated with adopting the new standard. Companies, especially those with extensive lease portfolios, faced considerable effort in gathering necessary data, implementing new systems, and training personnel to comply with the new rules.32
Another point of contention has been the potential impact on financial ratios and loan covenants. The increased recognition of Lease Liability on the Balance Sheet can lead to higher debt-to-equity ratios, potentially affecting a company's perceived creditworthiness or triggering existing loan agreement clauses.30, 31 While these changes reflect a more accurate financial picture, they necessitated careful management and communication with lenders and stakeholders.
Furthermore, despite the goal of convergence, differences persist between ASC 842 and IFRS 16, particularly in the expense recognition pattern for Operating Lease arrangements. This divergence can still lead to inconsistencies in financial statements for multinational corporations reporting under both GAAP and IFRS.29 The transition itself was not without its "snafus," as companies and accountants grappled with the highly technical details of the standard.28
Accounting Standards Codification 842 vs. ASC 840
The primary distinction between Accounting Standards Codification 842 (ASC 842) and its predecessor, Accounting Standards Codification 840 (ASC 840), lies in the treatment of leases on the balance sheet. Under ASC 840, leases were categorized primarily as either Capital Lease (now termed Finance Lease under ASC 842) or Operating Lease.26, 27 Capital leases were recognized on the balance sheet with an asset and a liability, similar to purchased assets.24, 25 However, operating leases were largely kept off the balance sheet, with lease payments typically expensed on a straight-line basis through the Income Statement, and obligations disclosed only in the footnotes of financial statements.21, 22, 23
ASC 842 fundamentally changed this by requiring nearly all leases with a Lease Term greater than 12 months to be capitalized on the balance sheet.19, 20 This means that for operating leases, companies now recognize a Right-of-Use Asset and a Lease Liability, thereby bringing these obligations into full view on the balance sheet.17, 18 While the classification of leases as finance or operating still exists under ASC 842, the impact on the balance sheet is similar for both types, unlike the stark difference under ASC 840.15, 16 This shift was a direct response to feedback from the investing community and regulators, who sought greater transparency regarding companies' lease-related obligations.13, 14
FAQs
Q1: Why was ASC 842 introduced?
A1: ASC 842 was introduced by the Financial Accounting Standards Board (FASB) primarily to increase transparency and comparability in Financial Reporting. The previous standard allowed many Operating Lease agreements to be kept off the Balance Sheet, making it difficult for investors to understand a company's full financial obligations.10, 11, 12
Q2: What are the main impacts of ASC 842 on financial statements?
A2: The most significant impact is on the balance sheet, where nearly all leases are now recognized as Right-of-Use Asset and Lease Liability. This increases reported assets and liabilities. The Income Statement impact varies depending on whether a lease is classified as a finance or operating lease, affecting the timing and nature of expense recognition.7, 8, 9
Q3: Does ASC 842 apply to all types of leases?
A3: ASC 842 applies to the majority of leases and subleases with a Lease Term longer than 12 months.5, 6 However, certain types of leases, such as those for intangible assets, biological assets, or inventory, are generally outside the scope of Topic 842.4
Q4: How do I calculate the lease liability under ASC 842?
A4: The Lease Liability is calculated as the Present Value of the remaining lease payments over the lease term. This calculation requires using a Discount Rate, which is typically the rate implicit in the lease or the lessee's incremental borrowing rate if the implicit rate is not readily available.1, 2, 3