Scope

ASC 842 replaced ASC 840 for lease accounting, requiring lessees to recognize substantially all leases on the balance sheet as right-of-use (ROU) assets and corresponding lease liabilities. The standard was issued through ASU 2016-02 and was effective for public business entities for annual periods beginning after December 15, 2018, and for other entities for periods beginning after December 15, 2021 (delayed twice for private companies).

Scope covers contracts that convey the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. Excluded: leases of intangible assets, biological assets, inventory, assets under construction, and certain natural resource leases. Short-term leases (12 months or less, no purchase option reasonably certain to be exercised) can be elected out by lessee policy.

Identifying a lease

ASC 842-10-15-2 through 15-9 govern the identification analysis. A contract contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. "Control" requires both:

The right to obtain substantially all of the economic benefits from use of the identified asset, and
The right to direct the use of the identified asset (or, if how and for what purpose were predetermined, the right to operate the asset, or the customer designed the asset).

The "identified asset" test is met when the asset is explicitly or implicitly specified in the contract and the supplier does not have a substantive substitution right. Supplier substitution rights are substantive only if (a) the supplier has the practical ability to substitute, and (b) the supplier would benefit economically from substitution.

Many service contracts with embedded equipment fail the lease test because the supplier retains substantive substitution rights or because the customer does not have the right to direct use. But many do contain leases — particularly contracts for IT equipment, vehicles, manufacturing equipment, and real estate space within larger facilities. The identification analysis is the most overlooked step in ASC 842 implementation.

Lessee classification

ASC 842-10-25-2 establishes the lessee classification criteria. A lease is a finance lease if it meets any of:

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
The lease term is for the major part of the remaining economic life of the underlying asset.
The present value of the sum of the lease payments and any residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset.
The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

Leases that meet none of these criteria are operating leases. Note that the classification criteria removed the bright-line tests under ASC 840 (75% of useful life, 90% of fair value) and replaced them with "major part" and "substantially all" — although those terms are commonly interpreted at the same bright-line thresholds in practice.

Lessee recognition and measurement

At lease commencement, the lessee recognizes:

A right-of-use asset at cost, including the lease liability, prepaid lease payments, initial direct costs, and estimated decommissioning or restoration costs.
A lease liability at the present value of the unpaid lease payments, discounted using the rate implicit in the lease (if readily determinable) or the lessee's incremental borrowing rate.

Lease payments include fixed payments, variable payments based on an index or rate (measured using the index/rate at commencement), exercise prices of purchase options reasonably certain to be exercised, and termination penalties expected to be paid. Variable payments based on usage or performance are not included in the lease liability — they are expensed as incurred.

Subsequent accounting differs by lease classification:

Finance lease:

ROU asset amortized straight-line over the shorter of useful life and lease term (generally; subject to the criteria 5 specialized-asset exception).
Lease liability accreted using the effective interest method.
P&L shows separate amortization expense and interest expense (front-loaded total expense profile).

Operating lease:

Single straight-line lease expense over the lease term.
ROU asset reduced to balance the lease liability accretion against the straight-line expense.
P&L shows a single lease expense line.

This dual-model approach for lessees is the major US GAAP / IFRS divergence point. IFRS 16 has a single model — all lessee leases are accounted for like ASC 842 finance leases. A US registrant with non-US subsidiaries will have material reconciling items between local IFRS books and US GAAP consolidation.

Lessor accounting

Lessor accounting under ASC 842 largely mirrors the legacy ASC 840 framework. Lessors classify leases as:

Sales-type leases — if any of the lessee classification criteria 1–5 are met. The lessor derecognizes the underlying asset and recognizes a net investment in the lease (and a selling profit or loss, if applicable).
Direct financing leases — if both (a) the present value of lease payments and any residual value guarantee equals or exceeds substantially all of the fair value, and (b) it is probable that the lessor will collect the lease payments plus residual value. The lessor derecognizes the underlying asset and recognizes a net investment in the lease, with no selling profit.
Operating leases — all others. The lessor retains the underlying asset and recognizes lease income generally straight-line over the lease term.

Lease modifications

ASC 842-10-25-8 through 25-18 govern modifications. Modifications that grant additional rights of use (e.g., expanding the leased space) and reflect standalone pricing are treated as a separate new lease. Modifications that change scope or consideration in other ways are reassessed — the lease is remeasured at the modification date, with the ROU asset adjusted for the change in lease liability.

For lessees, the practical implication: every modification triggers a remeasurement event. Discount rate must be updated to current; lease term and payment changes must be reflected. Many lease portfolios contain dozens of modifications per year (extensions, partial space surrenders, rent abatements, rent escalation deferrals); each one requires its own remeasurement.

Practical expedients

ASC 842 offers transition and ongoing practical expedients. The transition package (ASC 842-10-65-1) allows entities adopting the standard to:

Not reassess whether expired or existing contracts contain leases
Not reassess the lease classification of expired or existing leases
Not reassess initial direct costs for existing leases

These three are elected as a package. Most entities elected all three.

Ongoing expedients include:

Short-term lease exemption — election to not apply ASC 842 to leases of 12 months or less (no purchase option reasonably certain to be exercised). Expense as incurred.
Combine lease and non-lease components — by class of underlying asset, the lessee can elect to account for lease and non-lease components together. Simplifies real estate (where common area maintenance often accompanies lease payments).
Use a risk-free rate as the incremental borrowing rate — election available to non-public entities only.

Disclosure requirements (ASC 842-20-50 for lessees)

Information about leases (general description, terms, options, restrictions)
Lease cost components (operating lease cost, finance lease cost, short-term lease cost, variable lease cost, sublease income)
Other information (weighted-average remaining lease term, weighted-average discount rate, cash paid for amounts included in measurement, ROU assets obtained in exchange for lease liabilities)
Maturity analysis of lease liabilities by year for five years and thereafter, with reconciliation to the lease liability total

Common pitfalls

Missing embedded leases. Service contracts that include the right to use specified IT equipment, vehicles, or facilities often contain leases. The implementation pass typically catches the obvious leases (real estate, fleet); the embedded leases get found in subsequent audit testing.
Using the wrong discount rate. The rate implicit in the lease is rarely available to the lessee; the incremental borrowing rate (IBR) is what's actually used. The IBR must reflect a collateralized rate for the lease term and currency. Using the parent company's unsecured borrowing rate, or a corporate cost of capital, is wrong.
Lease liability remeasurement neglected after modification. Each modification triggers remeasurement. Companies often process modifications without recalculating, leading to year-end clean-up entries that should have been monthly.
Variable payments based on index or rate. Payments tied to CPI or a benchmark rate are included in the initial lease liability measurement at the index/rate at commencement. Subsequent changes to the index/rate generally do NOT remeasure the liability unless there's another remeasurement trigger. This counterintuitive treatment is missed frequently.
CAM and other operating costs. In real estate, common area maintenance, taxes, and insurance pass-throughs may or may not be lease components. The default is that they're non-lease (service) components, unless the entity elects the practical expedient to combine. Either way, they need to be identified.
Sale-leasebacks treated like the old rules. Sale-leaseback accounting under ASC 842 is materially different from ASC 840 — the sale must qualify as a sale under ASC 606 first, before the leaseback is accounted for. Many transactions that worked under ASC 840 don't qualify under ASC 842/606.

Operator note

I implemented ASC 842 (then still ASU 2016-02 in its post-issuance pre-adoption window) as Director of Finance at NBCU Parks & Resorts. The lease portfolio across the parks operation was material — concession arrangements with retail and food-service tenants, equipment leases on attractions and back-of-house, fleet vehicles, IT equipment, and the corporate real estate footprint. The implementation was a multi-quarter project running in parallel with the daily operations of a $2B+ subsidiary.

Three things I'd flag for anyone implementing or auditing 842 at scale:

First, the lease inventory exercise is everything. The accounting is mechanical once you have a clean inventory; the mistakes happen because the inventory is incomplete or stale. A company that hasn't done a lease-by-lease walkdown in the last 18 months almost certainly has missing leases in inventory. Build the inventory as a first-class operational dataset, not as a one-time implementation artifact.

Second, the discount rate is where audit attention concentrates. The IBR must be supportable — collateralized rate, lease-term-matched, currency-matched, reflective of the lessee entity's creditworthiness (not the parent's). Build a discount rate file with the underlying yield curve data, the credit spread, and the support for the collateralized adjustment. Auditors will test it every year.

Third, modifications are the long-tail problem. Lease accounting at adoption is a project. Lease accounting after adoption is operations. Without a process for capturing modifications as they happen and triggering the remeasurement, the lease liability will drift from reality and the year-end fix becomes painful. Build modification capture into the procurement and real estate workflows, not into the close.

At AGM today, the lease portfolio is smaller but no less operationally important — restaurant locations with landlord arrangements (Coldwell-style rolled into base occupancy), equipment leases on point-of-sale and back-of-house equipment, vehicle leases. The mechanics are the same; the discipline of inventory and modification capture is what separates a clean lease accounting environment from a constantly-broken one.

Related references

IFRS 16 — the converged international counterpart (single lessee model)
ASC 360 — Property, Plant, and Equipment (lessor underlying assets)
ASC 606 — for the sale-leaseback sale qualification
ASC 805 — for leases acquired in a business combination