Lease Accounting (ASC 842)
Lease Accounting under ASC 842 is the US GAAP standard that requires lessees to recognize a right-of-use asset and a corresponding lease liability on the balance sheet for most lease arrangements, replacing the prior standard that kept operating leases off-balance-sheet.
ASC 842, effective for public companies starting in 2019, fundamentally changed how US companies present leases in their financial statements. Before this standard, operating leases — which covered everything from office space to fleet vehicles — were disclosed only in footnotes. The prior standard, ASC 840, allowed companies to keep the present value of those future obligations entirely off the balance sheet, understating leverage and distorting comparisons.
Under ASC 842, a lessee must recognize a right-of-use (ROU) asset representing the right to use the underlying asset and a lease liability representing the obligation to make lease payments. The measurement is the present value of future lease payments, discounted at the rate implicit in the lease or, if that rate is not readily determinable, the lessee's incremental borrowing rate.
The standard distinguishes between finance leases (formerly called capital leases) and operating leases. Both require balance sheet recognition, but they differ in income statement treatment. Finance leases produce front-loaded interest expense plus depreciation, while operating leases produce a straight-line lease cost. The distinction affects reported EBITDA, EBIT, and net income differently, which matters for credit analysis and valuation multiples.
The practical impact for many companies was significant. Retailers, airlines, restaurants, and other businesses with large real estate or equipment lease portfolios saw substantial increases in reported total assets and total liabilities upon adoption. Debt-to-equity and debt-to-EBITDA ratios changed materially, requiring recalibration of loan covenants, compensation benchmarks, and analyst models.
Short-term leases (under 12 months) and low-value asset leases are exempt from full balance sheet recognition. Companies must also reassess variable lease payments, lease term renewal options, and embedded leases in service contracts — areas that require significant judgment.