How are leases treated in US GAAP?

All leases are treated in a manner similar to finance leases under ASC 842. asset is
amortized on a straight-line basis. The lease liability is accreted using the interest method,
and is decreased for payments made.

Scope of ASC 842: What’s covered

and what’s not covered?
ASC 842 applies to most leases and subleases, but exceptions do exist. On
occasion, a contract contains a lease, but it’s out of the scope of Topic 842 and the
guidance should not be applied to the transaction. Here are the out-of-scope lease
types, as detailed in Subtopic 842-10-15-1:
1. Leases of intangible assets, such as cloud computing arrangements. The
guidance for these agreements can be found in ASC 350, Intangibles –
Goodwill and Other.
2. Leases for the exploration or use of non-regenerative natural resources such
as oil, natural gas, and minerals are covered under ASC 930, Extractive
Activities – Mining, and ASC 932, Extractive Activities – Oil and Gas.
3. Leases of biological assets such as plants, animals, and timber. These are
addressed in ASC 905, Agriculture.
4. Leases of inventory, which are covered under ASC 330, Inventory.
5. Leases of assets that are under construction. These are addressed in ASC
360, Property, Plant, and Equipment.

ASC 842 subtopics: Lease types in

scope
ASC 842 is made up of five subtopics – an overview and four sections covering the
following transaction types:
 Lessee accounting for operating leases and finance leases
 Lessor accounting
 Sale-leaseback transactions
 Leveraged lease arrangements

Lessee accounting under ASC 842

Similar to ASC 840, the prior lease accounting standard, ASC 842 uses a two-
model approach for lessees; each lease is classified as either a finance lease or an
operating lease. This applies to all leased asset categories covered under the
standard, including leases of equipment and real estate. “Finance lease” is a new
term and replaces the term, “capital lease,” used under Topic 840. Additionally,
ASC 842 changes the criteria defining a finance/capital lease.
Lessees reporting under Topic 842 are required to recognize both the assets and the
liabilities arising from their leases. The lease liability is measured as the present
value of lease payments, while the lease asset is equal to the lease liability
adjusted for certain items like prepaid rent, initial direct costs, and lease
incentives.

Among the many changes to lease accounting under this standard, the most
significant is operating leases will be recorded on the balance sheet as lease assets
and lease liabilities. The asset is known as the right-of-use asset, or ROU asset,
and represents the lessee’s right to use the underlying asset while the lease liability
represents the lessee’s financial obligation over the lease term. When measuring
the assets and liabilities, both the lessee and the lessor should also include
“reasonably certain” lease renewals beyond the current lease term and “reasonably
certain” asset purchase options.
For leases with terms of 12 months or less, lessees can elect not to recognize lease
assets and liabilities. They should instead recognize lease expense on a straight-
line basis, generally, over the term of the lease, similar to the accounting treatment
under ASC 840.
Existing capital leases will not require adjustment or remeasurement upon
transition, but they will be referred to as finance leases.
Operating lease accounting under ASC 842 and
examples
When accounting for an operating lease, the lessee must:
1. Recognize a single lease cost allocated over the lease term, generally on a
straight-line basis
2. Classify all cash payments within operating activities on the statement of
cash flows
For a full example of an operating lease beginning pre-transition and the
accounting treatment at transition, read our article, “Operating Lease Accounting
under ASC 842 Explained with a Full Example.”
Below is an example of the accounting for an operating lease beginning post-
transition. For the example, let’s assume the following facts:
 Payment terms: $20,000 annually
 Start Date: 1/1/2023
 End Date: 12/31/2026
 Incremental Borrowing Rate (IBR): 3%
  The lessee determines this is an operating lease
Based on these circumstances, the present value of 4 annual payments of $20,000,
made in advance, with a 3% IBR is $76,572. The annual operating lease expense is
$20,000, or the straight-line treatment of 4 annual payments with no escalations,
rent holidays, etc. The amortization schedule for this lease is below.

The entry to record the lease upon its commencement is a debit to ROU asset and a
credit to lease liability:

Subsequent entries follow the amounts set forth in the amortization table. The entry
for the annual activity of 2023 is below.

Finance lease accounting under ASC 842 and

examples
When accounting for finance leases, lessees must:
1. Recognize interest on the lease liability and amortization of the ROU asset
in separate line items of the income statement
2. Classify payments of the principal portion of the lease liability within
financing activities and payments of interest on the lease liability within
operating activities on the statement of cash flows
Per the guidance, existing capital leases will not require adjustment or
remeasurement upon transition, provided they were accounted for correctly under
ASC 840. Therefore the accounting treatment of a capital/finance lease beginning
pre-transition will be the same as the accounting required post-transition and no
transition accounting adjustments will be necessary.
However, one exception is if any deferred or prepaid rents associated with the
capital/finance lease exist at transition. Any remaining balances of deferred or
prepaid rents become adjustments to the related ROU asset.
We’ve detailed a full example of a finance lease beginning post-transition in
another article, “Capital Lease Accounting and Finance Lease Accounting: A
Full Example.”
Download the Ultimate ASC 842 Guide for more examples
Our Ultimate Lease Accounting Guide for ASC 842 contains 44 pages of
examples, journal entries, disclosures, and more step-by-step guidance on
operating leases and finance leases under the new standard.

Lessor accounting under ASC 842

Lessor accounting remains largely unchanged from ASC 840 to 842. Lessors can
classify leases as operating, sales-type, or direct financing leases, but the leveraged
lease type under ASC 840 is eliminated under ASC 842. Lessor accounting is
covered in full detail in ASC 842-30. No significant changes were made to the
requirements for balance sheet recognition.
For operating leases, the leased asset will continue to be recognized as a fixed
asset on the lessor’s books. Whereas for both sales-type and direct financing
leases, the lessor derecognizes the underlying leased asset and records a net
investment in the lease on the balance sheet. While income from operating leases is
recognized on the income statement as rental income; when cash is received from
sales-type and direct financing leases, a portion is applied as a reduction to the net
investment in the lease, and a portion is recognized as interest income.
Read more about accounting for lessors in our article, “Lessee vs. Lessor:
Differences, Accounting, & More Explained”
Sale-leaseback accounting under ASC 842
In a sale-leaseback transaction, the lessee sells the asset to the buyer/lessor and
enters into an agreement to lease the asset back from the buyer/lessor. This type of
transaction consists of both a sale and a lease. The determination of whether or not
the transaction is a sale is performed in accordance with ASC 606, Revenue from
Contracts with Customers.
As a result of the changes under both ASC 606 and ASC 842, some transactions
not qualified for sale and leaseback accounting under ASC 840 will qualify under
ASC 842. The opposite is also true: some sale-leaseback transactions under ASC
840 will no longer qualify for this accounting under ASC 842. However,
transactions correctly accounted for using sale-leaseback accounting under ASC
840 do not have to be reassessed during the transition to ASC 842.
For a full example of a sale-leaseback transaction, read our article, “Sale-
leaseback Accounting under ASC 606 and ASC 842 Explained.”
Leveraged lease accounting under ASC 842
Under Topic 840, a leveraged lease is defined as an agreement in which the lessor
borrows funds from a lender to help pay for the purchase of an asset that is then
leased to a lessee. The lender holds the title of the asset and the lease payments
made by the lessee are collected by the lessor. The lessor is then responsible for
sending payments to the lender.
As we mentioned above, ASC 842 essentially eliminates the leveraged lease
classification. Lessors can only classify a lease arrangement as a leveraged lease if
the commencement date is prior to the effective date of the new lease accounting
standard. The accounting is detailed in ASC 842-50.
Ultimately, this means no new leveraged leases will be created following the final
effective date of the new standard. Leases with a commencement date falling after
an entity’s effective date for ASC 842 should be accounted for in accordance with
the rules for lessor accounting (covered earlier in this article) contained in ASC
842-30.

ASC 842 practical expedients

Topic 842 offers elections meant to ease the transition process, referred to as
practical expedients. Some of the practical expedients under ASC 842 include
grandfathering of lease classification, combining lease and non-lease
components, and not restating the prior year’s financials.
A more thorough explanation of the various practical expedients available can be
found in our article “Practical Expedient in Accounting Explained: Adopting
ASC 842 and IFRS 16 with Ease.”

ASC 842 disclosure requirements

ASC 842 requires both qualitative and quantitative disclosures. A few of the
specific disclosures required are:
 Discussions covering the lease arrangements
 Descriptions of significant judgments made
 Details about the lease costs reported on the income statement
 Weighted-average analysis of discount rates and remaining lease terms
We provide a full overview of the disclosure requirements of ASC 842 with
examples in our article, “ASC 842 Disclosure Requirements: Example and
Explanation.”

ASC 842 vs. IFRS 16: What are the

differences between the two?
Despite the Boards’ efforts to streamline lease accounting with the convergence of
these new standards, some major differences between the two standards emerged.
For example, ASC 842 continues to distinguish between finance and operating
leases, both are now required to be recorded on the balance sheet. Alternatively,
IFRS 16 removes the operating lease classification and requires that all lessee
leases be treated as finance leases.
Here are a few more examples of how the two differ:
1. Under IFRS 16, the lease liability is remeasured each time the reference
index or a rate that variable lease payments are tied to resets, whereas ASC
842 does not require the lease liability to be remeasured when indices or
rates are reset.
2. Though FASB Topic 842 does not explicitly exclude immaterial leases or
low-value assets, these are exempt from balance sheet recognition under
IFRS 16. The Basis for Conclusions paragraph 100 to IFRS 16 addresses
how companies can define “low value” assets and offers a threshold of
$5,000 for consideration.
3. FASB Topic 842 permits private companies to use a risk-free rate to
calculate the lease liability, but IFRS 16 does not provide guidance specific
to private entities.
4. While FASB Topic 842 generally requires interest payments to be included
within operating activities on the statement of cash flows, IFRS 16 allows
interest to be reported within operating, investing, or financing activities.

Right-of-Use Asset (ROU Asset)

and Lease Liability for ASC 842,
IFRS 16, and GASB 87 Explained
with an Example
by Jaron Moss, Technical Accounting Consultant | Jun 3, 2023
1. What is a right-of-use asset?
2. What is a lease liability?
3. Right-of-use asset under ASC 842
 How to calculate the right-of-use asset under ASC 842
 Right-of-use asset accounting example
4. Right-of-use asset under IFRS 16
 How to calculate the right-of-use asset under IFRS 16
5. Lease asset under GASB 87
 How to calculate the lease asset under GASB 87
6. Right-of-use asset amortization
7. Lease liability calculation under ASC 842, IFRS 16, & GASB 87
 Private company practical expedient offered under ASC 842
8. Right-of-use assets and lease liabilities on the balance sheet: Placement and
impact
9. Summary

What is a right-of-use asset?

In lease accounting, a right-of-use asset, or ROU asset, is an asset that represents
a lessee’s privilege to use a leased item over the duration of an agreed-upon lease
term. In other words, the lessee is granted the authority to obtain the economic
benefit from the usage of an asset owned by another entity. Under GASB 87, this
asset is referred to as the “lease asset.”

What is a lease liability?

A lease liability, as appropriately named under three major standards
(ASC 842, IFRS 16, and GASB 87), is the financial obligation to make the
payments arising from a lease, measured on a discounted basis.

Right-of-use asset under ASC 842

ASC 842 differs from GASB 87 and IFRS 16 as a result of retaining its dual-model
approach to presenting lease assets and lease liabilities on the balance sheet and
income statement. In other words, ASC 842 continues to distinguish
between operating leases and finance leases with each lease
classification requiring a capitalized ROU asset.
However, accounting for finance leases, previously referred to as capital
leases, under ASC 842 is largely unchanged compared to ASC 840. Under the old
standard, lessees were required to record an asset and liability for capital leases.
The same is true under ASC 842.
How to calculate the right-of-use asset under
ASC 842
Under ASC 842, initial operating and finance lease ROU assets are calculated
using the same method. Start with the initial amount of the lease liability,
computed by discounting the remaining lease payments, and adjust for any lease
payments made to the lessor at or before commencement, less any incentives
received, and any initial direct costs incurred by the lessee. Expressed as a formula
shown below:
Initial lease liability
+ Outstanding balance of prepaid rent
– Cumulative remaining deferred rent
+ Initial direct costs
– Lease incentives paid at or before the commencement of the lease
It is important to note that for basic leases, the ROU asset and lease liability will be
equal upon lease commencement. For example, if a company has a lease without
initial direct costs, prepaid/deferred rent, or a tenant improvement allowance (or
some other lease incentive), then the ROU asset and the lease liability will be equal
on the lease commencement date.
Right-of-use asset accounting example
Next, we will walk through a brief example of how to calculate the ROU asset for
an operating lease under ASC 842 assuming the facts below.
Entity Information:
Private Company
Fiscal Year End: December 31
Transition Date: January 1, 2022
Borrowing Rate: 5%
Lease Details:
Lease Term: 5 years
Lease Commencement: January 1, 2021
Lease End Date: December 31, 2025
Lease Payments: $2,500 due on the first of each month, starting January 1, 2021
Rent Escalation: Increases of 3% each year starting January 1, 2022.
Initial Direct Cost: $10,000 capitalized on lease commencement
Incentive: $20,000 cash received at lease commencement
First Step: Calculate the lease liability
For this example, take the contractual payments from January 1, 2022, the entity’s
transition date, through December 31, 2025, and apply the established borrowing
rate of 5% to calculate the lease liability.
Using the free present value calculator from our website returns a present
value of approximately $117,218 (rounded to the nearest dollar).
Second Step: Calculate the ROU asset
Since this lease commenced prior to the entity’s transition to ASC 842, to calculate
the value of the ROU asset we will first need to determine the incentive, initial
direct cost, and any prepaid/deferred rent balances as of December 31, 2021.
Prior to transitioning to ASC 842 the proper treatment of incentives and initial
direct costs was to capitalize them as of lease commencement and then depreciate
them on a straight-line basis over the lease term. In this example, we capitalized
the initial direct costs and incentive on the first day of the lease (January 1, 2021).
Below are portions of the amortization schedules for each of these items before the
entity’s effective date of ASC 842.
Under ASC 840, operating leases were accounted for by straight-lining the rent
expense over the lease term, creating deferred or prepaid rent. Deferred rent was
a result of rent payments increasing over time while rent expense stayed constant
due to the straight-line approach.
Below is a portion of the deferred rent schedule for the lease in this example.

With the appropriate incentive, initial direct cost, and deferred rent balances we are
able to calculate the initial ROU asset on January 1, 2022.
Initial Liability $
Balance 117,218

Less: Deferred Rent (1,855)

Plus: Initial Direct

8,000
Cost

Less: Incentive (16,000)

ROU Asset $ 107,363

Third Step: Create the amortization schedule

Once the lease liability and ROU asset have been calculated, calculate the rent
expense and create the amortization schedule to be used to create the periodic
journal entries.
The total lease expense for an operating lease under ASC 842 is the sum of the
remaining payments as of the transition date adjusted for any deferred/prepaid,
incentive, or initial direct cost balances, divided by the remaining term of the lease.
In this example, the total remaining cash payments equal $129,276, as shown in
the payment schedule below.
The total remaining cash payments are then adjusted for the remaining balances of
deferred rent, incentives, and initial direct costs as of December 31, 2021, included
in the ROU asset calculation, as shown below.
$
Total cash payments
129,276

Less: deferred rent (1,855)

Plus: initial direct

8,000
cost

Less: incentive (16,000)

$
Net payments
119,421

The total net payment amount of $119,421 is divided by the remaining lease term
of 48 months (January 1, 2022 – December 31, 2025) to calculate a lease expense
of $2,488. The initial lease liability and ROU asset as of January 1, 2022, and the
calculated lease expense are used to create the amortization table, a portion of
which is shown below.
Download the Ultimate Lease Accounting Guide for more
examples
Our Ultimate Lease Accounting Guide includes 44 pages of examples, journal
entries, disclosures, and more step-by-step guidance on operating leases and
finance leases under ASC 842.

Right-of-use asset under IFRS 16

A classification distinction between operating and finance leases does not exist
under IFRS 16. Rather, a single model approach is applied whereby all lessee
leases post-adoption are reported as finance leases. These leases are capitalized and
presented on the balance sheet as both assets and liabilities, unless subject to any of
the exemptions prescribed by the standard. IFRS 16 also refers to the lease asset as
an ROU asset.
How to calculate the right-of-use asset under
IFRS 16
IFRS 16 directs lessees to calculate the ROU asset as the following:
The initial amount of the lease liability
+ Payments made at or before the commencement of the lease
– Lease incentives
+ Initial direct costs
+ Estimated costs for restoration or removal/disposal per IAS 37 Provisions,
Contingent Liabilities, and Contingent Assets

Lease asset under GASB 87

Similar to IFRS 16, GASB 87 uses a single-model approach and classifies all
leases as finance leases. GASB 87 also requires the lessee to recognize an
intangible right-to-use lease asset, referred to as a lease asset, in conjunction with a
lease liability. However, in order to do so, the reporting entity must have the right
to control and obtain economic benefit from the present service capacity of the
underlying asset.
In addition, the following types of leases are exempt from recognizing a right-to-
use asset and lease liability under GASB 87:
 Leases not meeting the definition of an exchange-like transaction
 Leases containing a provision for a title transfer
 Leases with a lease term of 12 months or less, including renewal options
regardless of intention to exercise
When capturing the activity within the governmental fund, a conversion entry
will be necessary at year-end to convert from the modified accrual accounting basis
to the full accrual basis required for government-wide financials.
How to calculate the lease asset under GASB 87
In order to compute the initial leased asset amount a lessee should take the total of:
The initial lease liability
+ Outstanding prepaid rent amounts
– Any cumulative remaining deferred rent
– Unamortized incentive balances received at or before the commencement of the
lease
+ Initial direct costs incurred to place the asset into service

Right-of-use asset amortization

ASC 842 requires the right-of-use asset for operating leases to be amortized
differently than for finance leases. The right-of-use asset for an operating lease is
amortized in a systematic and rational basis by subtracting the liability lease
expense from the total lease expense. Finance lease assets are amortized on a
straight-line basis.
ASC 842 also requires operating lease ROU assets to be amortized from the lease
commencement date (the date the lessee obtains possession of the underlying asset)
to the end of the lease’s term. In some cases, it may be from the commencement
date to the end of the useful life of the asset. The same holds true for finance leases
under ASC 842, IFRS 16, and GASB 87.
Lease liability calculation under ASC
842, IFRS 16, & GASB 87
A lease liability is the financial obligation for the payments required by a lease,
discounted to present value. Under ASC 842, IFRS 16, and GASB 87, the finance
lease liability is calculated as the present value of the lease payments remaining
over the lease term. The preferred discount rate to use is the discount rate implicit
in the lease under each of the three major lease standards. However, each standard
also allows for the use of an incremental borrowing rate defined by the standard
in specific circumstances when the implicit interest rate can not be determined.

IFRS 16 also requires lessees to remeasure lease liabilities when future payments
change, potentially affecting balances when the lease payments are tied to an
index. This is not the case, however, under GASB 87 and ASC 842. For more
detail on this, read our blog, “IFRS 16 vs. ASC 842 (US GAAP) Lease
Accounting: What Are the Differences?“
Under ASC 842, initial operating lease liabilities and finance lease liabilities are
calculated using the exact same method.
Private company practical expedient offered
under ASC 842
ASC 842 offers an additional interest rate option to private companies and
nonprofits. Non-public entities have the option to elect a risk-free rate as the
discount rate for lease liability calculations. As a result of the FASB’s post-
implementation review process, private entities can apply the risk-free rate by class
of underlying asset rather than having to apply it to the entire lease portfolio.

Right-of-use assets and lease liabilities

on the balance sheet: Placement and
impact
An operating lease is a contract providing a lessee the right to use an asset without
the benefits of ownership. Despite companies’ obligations to make the lease
payments associated with their operating leases, ASC 840 and IAS 17 did not
require a lease asset or a lease liability to be recorded on the balance sheet, nor
did GASB require recording an asset or liability on the statement of the net
position under GASB 13 or GASB 62.
ASC 842, IFRS 16, GASB 87, however, now require the capitalization of almost
all leases – a major shift in the way lessees account for their operating leases.
Aside from the ability to take advantage of a policy election allowing a lessee to
account for leases with terms shorter than 12 months similar to an operating lease
under the legacy standards, and a few other exemptions seen under GASB 87, all
leases must be recognized on the balance sheet with a lease liability and ROU
asset, calculated at initial recognition as discussed at the beginning of the article.
Operating lease classification has also changed under all three standards, but in
different ways. Under IFRS 16 and GASB 87, all leases are classified as finance
leases, eliminating the “operating lease” classification. This isn’t the case for ASC
842, though, which makes the following changes to the lease classification
criteria:
 A bargain purchase option criteria no longer exists. If the lease contains an
option to purchase the underlying asset the lessee is reasonably certain to
exercise, the lease qualifies as a finance lease.
 The “75% of lease term” and “90% of FMV” rules are no longer definitive.
However, the FASB has suggested companies should continue to use these
thresholds in their analyses, unless a more appropriate threshold exists,
based on the company’s facts and circumstances. Entities need to develop an
overall policy with regard to these thresholds to use consistently.
 A new fifth test has been added – entities must now consider whether or not
the asset is specialized in nature and has any future value to the lessor.
This is primarily a result of the FASB moving away from “rules” based accounting
to “principle” based accounting.

Summary
Regardless of which lease accounting standard is adopted, each standard will result
in the recognition of a right-to-use asset and lease liability on the balance sheet
upon transition. Reporting entities must have a firm grasp of the financial
statement presentation and the methods of computing the ROU asset and
corresponding lease liabilities, as each guidance has its own nuanced definition of
what is deemed a reportable lease and what variables factor into the calculations.
This comprehensive guide on understanding the ROU asset as it relates to both
finance and operating leases should help in future calculations. If it’s unclear what
type of lease the organization has, LeaseQuery offers a number of free lease
accounting tools to help. To learn more, schedule a LeaseQuery demo today.
Capital/finance lease vs. operating
lease accounting treatment
Both finance and operating leases represent cash payments made for the use of an
asset. However, because of the distinction between the two types of leases, it is
worth mentioning the differences in the mechanics of the accounting for each.
The cash payments made for each lease must have a corresponding expense. This
expense represents the lease cost and may differ slightly from the cash payment
made each period.
Operating lease accounting
Operating lease payments under ASC 840 were often recorded to rent expense as
simply a debit to expense and a credit to cash. Operating lease accounting under
ASC 842 is more complex. To summarize, a right-of-use asset and a lease
liability must be established at lease commencement (or transition to ASC 842),
and then reduced over the remaining lease term in addition to recording the cash
payment and lease expense.
The total lease expense booked under ASC 842 for operating leases is comprised
of an asset lease expense and a liability lease expense and is equal to the total
amount of required cash payments allocated evenly over the lease term. The
liability lease expense represents the interest accrued on the lease liability each
period and the asset lease expense represents the amortization of the lease asset.
The lease liability is reduced by the periodic cash payment, less any interest
accrued on the lease liability balance. The lease asset is reduced by the periodic
lease asset expense. Below is an example of an operating lease amortization
schedule showing:
(1) Cash payments
(2) Liability lease expense
(3) Liability reduction
(4) Asset lease expense, and
(5) Total lease expense under ASC 842:
Capital/finance lease accounting
Accounting for finance leases under ASC 842 is much the same as capital lease
accounting under ASC 840. Similar to operating leases, a right-of-use asset and
lease liability must be established at lease commencement (or transition to ASC
842), and then reduced over the remaining lease term.
The finance lease liability is treated as capital lease liabilities were – the lease
payments are split between the interest expense incurred on the lease liability and
a lease liability reduction amount. The right-of-use asset is reduced by amortization
expense like capital lease assets were reduced by depreciation expense. Below is
an example of a finance lease amortization schedule under ASC 842:

Download our Ultimate Lease Accounting Guide for detailed examples of finance
and operating lease accounting
Are you looking for more detail on finance and operating lease accounting under
ASC 842? Our Ultimate Lease Accounting Guide includes 44 pages of
comprehensive examples, disclosures, and more.
Impact on the business
So, what is the business impact of ASC 842? Previously, operating leases were
considered off-balance-sheet transactions. Now, ASC 842 requires operating
leases to be recognized on the balance sheet as both an asset and a corresponding
liability. These new presentation requirements provide better representation of
lessees’ obligations to investors, creditors, and other financial statement users.
First we will look at the balance sheet. Since both capital/finance and now
operating leases require reporting a liability and asset, the total assets and liabilities
recognized on the balance sheet are increased. The asset and liability balances
associated with each lease type should be presented in separate line items resulting
in an operating right-of-use-assets line item and a finance right-of-use-assets line
item.
No impact to debt occurs when transitioning to ASC 842. However, companies
should consider how the new operating lease assets and liabilities could potentially
impact their financial ratios.
Let’s also consider the income statement. The classification of a lease helps
determine how the lessee recognizes expense. No change to expense is recognized
when transitioning from ASC 840 to ASC 842; therefore, the income statement
remains consistent. Operating leases will continue to recognize rent expense and
capital/finance leases will recognize both interest expense and amortization
expense.
Effectively, no impact to the income statement also means no impact to EBITDA.
However, situations may occur where leases classified as operating under ASC 840
may be considered finance leases under ASC 842 as a result of the additional
classification criteria, and vice versa. Please note the package of practical
expedients to evaluate the relief efforts at transition.

Frequently asked questions

Do we have to capitalize every lease?
All leases are subject to ASC 842. However, some fact patterns can create scope
exceptions for operating leases, allowing the lessee to skip capitalizing an asset and
liability onto the balance sheet – effectively keeping operating lease accounting
consistent with ASC 840 for these few scenarios.
The first exception is for short-term leases. Leases with a total term, including
renewal options reasonably certain to be exercised, of 12 months or less are exempt
from capitalization. Note that under ASC 842 this measurement is taken from lease
commencement to lease end, not your transition date to lease end.
The second exception is for leases which are deemed immaterial to financial
statement users. ASC 842 does not establish a materiality exception or threshold,
but materiality exemptions are allowed overall by US GAAP. If an entity has a
materiality threshold for fixed assets, a similar methodology may be applied to
leases as well.
One consideration, however, is that the materiality threshold for leases under ASC
842 must be applied to whole asset groups, not individual leases. For example, if a
company determines it has immaterial copier leases, it must aggregate all its copier
leases and analyze the total amount of copier leases for materiality to stakeholders .
The materiality threshold for leases is a subjective determination which must
ultimately be approved by your auditors.
Are all leases now finance leases?
No – the distinction between operating and finance (previously capital) leases
remains under ASC 842.
If leases are out of scope due to short-term
criteria or materiality, are they still required to be
disclosed in the footnotes?
Short-term lease cost, or the cash paid for leases under 12 months in total (which
will match the expense), is part of the overall required disclosures for “total lease
cost”. Leases which are deemed immaterial have no disclosure requirement.

Summary
The classification of an operating lease versus a finance lease under the new
guidance is determined by evaluating whether any of the finance lease criteria are
present. If a lease agreement contains at least one of the five criteria, it should be
classified as a finance lease.
A significant aspect of the new standard is that both operating leases and finance
leases must be recorded on a company’s balance sheet, whereas only capital leases
were previously recorded on the balance sheet.
Understanding how a lease is classified, the key differences from ASC 840 to ASC
842, and its impact to the business will equip your company for success under
the new lease accounting standard.