The Shift to ASC 842

ASC 842, Leases, fundamentally changed how organizations account for leases by requiring virtually all leases to be recognized on the balance sheet. Under the previous standard (ASC 840), operating leases were off-balance-sheet obligations – a treatment that critics argued obscured trillions of dollars in commitments from investors and analysts.

Now that ASC 842 has been fully adopted across both public and private companies, the focus has shifted from initial implementation to ongoing compliance, system maintenance, and handling the steady stream of new leases, modifications, and reassessments that flow through every organization.

Scope: What Is a Lease?

A contract is (or contains) a lease if it conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. The two key questions are:

  1. Is there an identified asset? – The asset must be explicitly or implicitly specified, and the supplier must not have a substantive right to substitute the asset.
  2. Does the customer control the use? – The customer must have the right to obtain substantially all of the economic benefits from use and the right to direct the use of the asset.

Common Gray Areas

  • IT equipment and cloud computing – Many hosting arrangements and IT service contracts do not contain a lease because the customer does not control specific, identified servers.
  • Embedded leases in service contracts – Facilities management, logistics, and outsourcing contracts often contain embedded leases for equipment or space.
  • Co-tenancy arrangements – Shared space in retail or office environments may or may not constitute a lease depending on the level of control.

Lease Classification

ASC 842 retains a dual-model approach for lessees. A lease is classified as a finance lease if it meets any one of the following criteria:

  1. The lease transfers ownership of the underlying asset by the end of the lease term.
  2. The lease grants a purchase option that the lessee is reasonably certain to exercise.
  3. The lease term is for the major part of the remaining economic life of the asset.
  4. The present value of lease payments equals or exceeds substantially all of the fair value of the asset.
  5. The asset is so specialized that it has no alternative use to the lessor at the end of the lease term.

If none of these criteria are met, the lease is classified as an operating lease.

Practical Guidance on “Major Part” and “Substantially All”

ASC 842 deliberately avoids the 75% and 90% bright-line tests from ASC 840. However, in practice, many organizations continue to use these thresholds as a starting point for their analysis, supplemented by qualitative judgment. Document your policy clearly and apply it consistently.

Initial Measurement

At the commencement date, the lessee recognizes:

  • A right-of-use (ROU) asset, measured as the initial amount of the lease liability, plus any lease payments made at or before commencement, plus any initial direct costs incurred, minus any lease incentives received.
  • A lease liability, measured at the present value of future lease payments over the lease term.

Discount Rate

Use the rate implicit in the lease if readily determinable. If not (which is the case for most leases), use the lessee’s incremental borrowing rate (IBR). The IBR should reflect:

  • The lessee’s credit standing
  • The lease term
  • The currency of the lease payments
  • The economic environment at commencement (or modification)

Determining the Lease Term

The lease term includes:

  • The non-cancelable period of the lease
  • Periods covered by an option to extend if the lessee is reasonably certain to exercise
  • Periods covered by an option to terminate if the lessee is reasonably certain not to exercise

Reassess the lease term only when a significant event or change in circumstances occurs that is within the lessee’s control.

Subsequent Measurement

Operating Leases

  • Lease expense is recognized on a straight-line basis over the lease term.
  • The ROU asset is adjusted so that total lease expense (liability interest accretion plus ROU asset amortization) equals the straight-line amount.

Finance Leases

  • Amortization of the ROU asset is recognized separately (typically straight-line).
  • Interest on the lease liability is recognized using the effective interest method.
  • The combined effect produces a front-loaded expense pattern.

Journal Entry Illustration – Operating Lease

Assume a 5-year office lease with annual payments of $100,000, no purchase option, and a 5% IBR. The present value of lease payments is approximately $432,948.

At commencement:

Account Debit Credit
ROU Asset $432,948
Lease Liability $432,948

Year 1 payment:

Account Debit Credit
Lease Expense $100,000
Lease Liability $78,353
ROU Asset $78,353
Cash $100,000

(The lease liability reduction equals the payment minus interest; the ROU asset reduction is a plug to achieve straight-line expense.)

Lease Modifications

Lease modifications are common and often the most operationally challenging aspect of ASC 842. A modification is any change to the terms and conditions of a lease that was not part of the original terms (e.g., adding space, extending the term, changing the payment amount).

Modification Framework

  1. Is the modification a separate contract? It is a separate contract if it grants an additional right of use that is distinct and the increase in consideration is commensurate with the standalone price. If yes, account for it as a new lease.
  2. If not a separate contract, remeasure the lease liability using a revised discount rate and adjust the ROU asset accordingly. The specific treatment depends on whether the modification effectively creates a new lease or changes the existing one.

Best Practices for Modifications

  • Centralize modification tracking. Lease modifications are often handled by real estate or procurement teams without timely notification to accounting. Build a workflow that routes all lease changes through accounting.
  • Reassess classification. A modification can change the lease classification. Re-run the classification tests whenever a modification occurs.
  • Update your IBR. The discount rate is revised at the modification date, not the original commencement date.

Practical Expedients and Elections

ASC 842 provides several practical expedients that can simplify ongoing accounting:

  • Short-term lease exemption – Leases with a term of 12 months or less (with no purchase option reasonably certain to be exercised) can be excluded from balance sheet recognition.
  • Non-lease component election – Lessees can elect, by asset class, not to separate non-lease components (e.g., common area maintenance) from lease components, instead accounting for the entire contract as a single lease.
  • Portfolio approach – Entities can apply ASC 842 to a portfolio of leases with similar characteristics if the result would not differ materially from applying the standard to individual leases.

When to Use the Portfolio Approach

The portfolio approach is most effective for organizations with large volumes of similar leases, such as vehicle fleets or standardized retail locations. It significantly reduces the computational burden while maintaining acceptable precision.

Common Implementation Challenges

Even for organizations that have completed their initial ASC 842 implementation, ongoing challenges persist:

  1. Data completeness – Ensuring that all leases (especially embedded leases and short-term leases) are captured in the lease accounting system.
  2. Discount rate updates – Maintaining current IBR curves and applying the correct rate at commencement and modification dates.
  3. Reasonably certain assessments – Documenting and periodically revisiting judgments about renewal and termination options.
  4. System integration – Ensuring that the lease accounting system communicates effectively with the general ledger, fixed asset system, and financial reporting tools.
  5. Transition of legacy leases – Handling leases that commenced under ASC 840 and are now being modified under ASC 842.

Building a Sustainable Lease Accounting Process

To maintain compliance without excessive manual effort, consider this framework:

  • Quarterly lease inventory review – Confirm that all new leases, modifications, and terminations have been captured.
  • Annual IBR refresh – Update your incremental borrowing rate methodology and curves at least annually, or more frequently if interest rates are volatile.
  • Segregation of duties – Separate the lease data input function from the accounting review and approval function.
  • Audit-ready documentation – Maintain a lease-by-lease file with the executed agreement, classification analysis, discount rate support, and modification history.

Final Thoughts

ASC 842 is no longer a transition project – it is an ongoing operational process. The organizations that manage it most effectively are the ones that treat lease accounting as a cross-functional discipline, invest in reliable systems and data, and maintain rigorous documentation. Approach each new lease and modification with the same discipline you applied during initial implementation, and the standard will be far more manageable over time.