If your business leases equipment, office space, or other assets, you’ve probably heard about Accounting Standards Codification (ASC) 842 —and you might be wondering how it affects you. It was introduced to enhance transparency in lease accounting, but the transition from ASC 840 to ASC 842 has brought a wave of complexity and confusion.
Previously, businesses could keep operating leases off the balance sheet, but now, nearly every lease needs to be accounted for as both a liability and an asset. This change aims to improve transparency, but it also means businesses must adapt their financial reporting, update systems, and rethink tax strategies.
For CFOs, controllers, and finance teams, navigating ASC 842 can feel overwhelming— especially when trying to determine discount rates, lease modifications, and classification rules. But don’t worry—this guide will break it down in simple, straightforward terms so you can understand how ASC 842 applies to your business and what steps you can take to stay compliant.
Key Takeaways
How ASC 842 Applies and Key Changes from Previous Standards
ASC 842 replaces ASC 840, changing how businesses report leases. Before this shift, only finance leases (formerly called capital leases) were recorded on the balance sheet, while operating leases remained off the books.
Now, nearly all leases lasting longer than 12 months must be recorded as both an asset and a liability—a change that could alter key financial ratios and impact lending agreements.
Key Changes in ASC 840 vs. ASC 842
ROU Assets & Liabilities
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ASC 840: Only finance leases were recorded on the balance sheet. Operating leases remained off-book.
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ASC 842: All leases longer than 12 months must be recorded as both a right-of-use asset and a lease liability, regardless of lease type.
New Lease Classification Approach
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ASC 840: Differentiated between capital leases and operating leases, where only capital leases affected the balance sheet.
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ASC 842: Replaces capital leases with finance leases, and all leases require recognition on the balance sheet. The classification determines how the lease expense is recognized on the income statement.
Impact on Discount Rates
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ASC 840: Businesses often used their incremental borrowing rate without strict guidance.
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ASC 842: Businesses must determine an appropriate discount rate, such as the incremental borrowing rate or the risk-free rate (for private businesses) to accurately calculate the lease liability.
Leaseback Transactions
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ASC 840: Allowed businesses to classify a sale-leaseback transaction as an immediate sale if risks and rewards were transferred.
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ASC 842: Imposes stricter criteria for qualifying as a sale-leaseback transaction, requiring businesses to recognize a lease asset and lease liability if the seller-lessee retains control.
Variable Lease Payments & Modifications
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ASC 840: Variable lease payments were often excluded from lease liability calculations.
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ASC 842: Requires businesses to track and account for variable lease payments, lease term changes, and lease modifications, which can alter lease accounting over time.
Journal Entry Example for ASC 842 Lease Recognition
When recording a new lease, a business will recognize:
Types of Leases Under ASC 842 and Their Classification
Under ASC 842, leases are classified into distinct categories based on the rights and obligations of the lessee and lessor. Here’s what you should know:
Lessee Lease Classifications:
1. Finance Lease (Previously known as a capital lease)
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The asset is effectively transferred to the lessee.
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The lease term covers the majority of the asset's economic life.
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The lease includes a bargain purchase option.
2. Operating Lease
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The lessee records a liability and ROU asset.
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Unlike finance leases, lease expenses are recognized on a straight-line basis over the lease term.
Lessor Lease Classifications:
2. Sales-Type Lease
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The lessor removes the leased asset from their books and recognizes a net investment in the lease.
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The lease must meet at least one of the five criteria (similar to lessee’s finance lease test) to qualify.
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Transfer of Ownership
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Purchase Option that is Reasonably Certain to be Exercised
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Lease Term Covers a Major Part of the Asset’s Economic Life
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Present Value of Lease Payments Approximates the Asset’s Fair Value
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The Asset is Specialized
Direct Financing Lease
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Similar to a sales-type lease, but the lessor defers profit recognition rather than recognizing an immediate gain.
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A lease qualifies as direct financing if it does not meet sales-type criteria but meets the present value test and does not result in a significant loss of residual asset value.
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The lessor records a net investment in the lease and recognizes interest income over the lease term.
Operating Lease
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The lessor retains the underlying asset on their balance sheet and continues to depreciate it.
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Lease payments are recognized as rental income on a straight-line basis over the lease term.
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The lessor remains responsible for the asset’s maintenance and residual value.
Impact of ASC 842 on Financial Reporting and Business Operations
This change doesn’t just affect accounting—it impacts how businesses report their financial health.
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Balance Sheet: Lease liabilities and right-of-use assets increase, potentially affecting debt ratios.
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Income Statement: Different expense recognition methods impact earnings.
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Cash Flow Statement: Lease payments are now categorized differently, affecting operating and financing cash flows.
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Business Operations: Companies need to update lease tracking systems and train staff on new accounting processes.
Tax Implications and Compliance Strategies for Businesses
ASC 842 also introduces important tax implications for businesses, particularly regarding deductible expenses and lease-related tax strategies.
Key Tax Considerations:
1. Lease Expense Deductions:
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Operating leases still provide a straight-line lease expense deduction.
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Finance leases recognize both interest and amortization, affecting tax liability.
2. Deferred Tax Liabilities:
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Recognition of lease liabilities and ROU assets can create timing differences for tax purposes.
3. Sale-Leaseback Transactions:
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New rules for sale-leaseback transactions impact whether a transaction qualifies as a sale for tax purposes.
4. Lease Modifications & Tax Impact:
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Changes to lease terms may result in tax recalculations each fiscal year.
Best Practices for Tax Compliance:
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Maintain accurate journal entries and supporting documentation for all leases.
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Consult tax professionals to navigate the implications of lease modifications.
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Utilize practical expedients where applicable to simplify compliance.
Optimizing Lease Accounting with Cathcap
Final Takeaways
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Businesses must now recognize nearly all leases on the balance sheet.
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Lease classification impacts income statements, cash flow, and tax strategies.
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Private companies should leverage available practical expedients for transition ease.
Implementing ASC 842 can be complex, requiring businesses to adapt their financial reporting processes. At Cathcap, we specialize in Fractional CFO Services, helping businesses adapt to complex financial changes with ease.
How We Can Help:
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Accurate Lease Accounting: Ensuring proper recognition of lease liabilities and right-of-use assets under ASC 842.
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Strategic Compliance Planning: Helping businesses transition smoothly and optimize financial performance.
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Cash Flow & Financial Impact Analysis: Evaluating how lease modifications, discount rates, and variable lease payments affect financial statements.
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CFO Advisory & Assessment: Providing expert guidance on complex lease agreements and journal entry adjustments.
By leveraging our expertise, businesses can ensure compliance with ASC 842, maintain accurate financial statements, and optimize lease accounting for long-term success. Contact us today for expertly tailored financial services!
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