ASC 842 Lease Accounting Example | CPA FAR Guide
ASC 842 Lease Accounting Guide (ROU Asset & Leases)
ASC 842 is the US GAAP lease accounting standard that requires lessees to recognise a right-of-use (ROU) asset and a lease liability on the balance sheet for virtually all leases exceeding 12 months. It replaced ASC 840 and fundamentally changed how operating leases are reported, bringing trillions of dollars in lease obligations onto corporate balance sheets.
- Both finance and operating leases now appear on the balance sheet under ASC 842
- ROU asset = present value of lease payments at commencement
- Finance leases: front-loaded expense (amortisation + interest); Operating leases: straight-line expense
- Short-term leases (12 months or less) may use the practical expedient to avoid recognition
- IFRS 16 uses a single model (all leases treated like finance leases) while ASC 842 retains dual classification
Table of Contents
- What Changed Under ASC 842?
- Finance vs Operating Lease Classification
- Worked Example With Journal Entries
- ASC 842 vs IFRS 16 Comparison
- Common Mistakes to Avoid
- Quick Glossary
- FAQ
- CPA FAR Exam Tips
What Changed Under ASC 842?
| Feature | Old Standard (ASC 840) | New Standard (ASC 842) |
|---|---|---|
| Operating leases | Off-balance sheet | On-balance sheet (ROU asset + lease liability) |
| Finance leases | On-balance sheet (called "capital leases") | On-balance sheet (renamed "finance leases") |
| Expense pattern | Operating: straight-line rent; Capital: front-loaded | Operating: straight-line; Finance: front-loaded |
| Short-term exemption | No specific guidance | Leases ≤12 months: optional off-balance sheet |
Finance vs Operating Lease Classification
A lease is classified as a finance lease if it meets ANY of these criteria:
- Transfer of ownership to lessee by end of lease term
- Purchase option that the lessee is reasonably certain to exercise
- Lease term is for a major part of the asset’s remaining economic life
- Present value of lease payments equals or exceeds substantially all of the asset’s fair value
- Asset is so specialised that it has no alternative use to the lessor
If none of these criteria are met, the lease is an operating lease.
Worked Example: Operating Lease Under ASC 842
Step 1: Calculate Present Value of Lease Payments
| Payment | Timing | Amount | PV Factor @5% | Present Value |
|---|---|---|---|---|
| Year 1 | At inception | $120,000 | 1.0000 | $120,000 |
| Year 2 | Start of Year 2 | $120,000 | 0.9524 | $114,286 |
| Year 3 | Start of Year 3 | $120,000 | 0.9070 | $108,844 |
Total PV (ROU Asset and Lease Liability at inception) = $343,130
Step 2: Journal Entry at Lease Commencement
1 Jan 2025:
Dr Right-of-Use Asset $343,130
Cr Lease Liability $343,130
Dr Lease Liability $120,000 (first payment reduces liability)
Cr Cash $120,000
After the first payment: Lease Liability = $343,130 - $120,000 = $223,130
Step 3: Monthly Expense Recognition (Operating Lease)
Total lease cost = $360,000 (3 x $120,000). Straight-line annual expense = $120,000/year or $10,000/month.
Monthly (Operating Lease):
Dr Lease Expense $10,000
Cr Right-of-Use Asset (amortisation portion)
Cr Lease Liability (interest accretion portion)
Key Point: For operating leases, the total expense is straight-line, but it is split between ROU asset amortisation and lease liability interest accretion.
ASC 842 vs IFRS 16: Key Differences
| Feature | US GAAP (ASC 842) | IFRS (IFRS 16) |
|---|---|---|
| Lessee model | Dual model: finance + operating | Single model: all leases treated like finance |
| Expense pattern (operating) | Straight-line single lease expense | Depreciation + interest (front-loaded) |
| Low-value exemption | Not available | Available (assets under ~$5,000 when new) |
| Short-term exemption | ≤12 months (by asset class) | ≤12 months (lease-by-lease) |
| Remeasurement | Only on triggering events | Required for index/rate changes |
| Income statement impact | Operating leases: single line; Finance: depreciation + interest | All leases: depreciation + interest (higher EBITDA) |
For deeper IFRS 16 guidance, explore our DipIFR coaching programme.
Common Mistakes to Avoid
- Forgetting initial direct costs: These are added to the ROU asset, not expensed immediately
- Wrong discount rate: Use the rate implicit in the lease if determinable; otherwise use the incremental borrowing rate
- Ignoring lease modifications: Remeasure the liability when lease terms change
- Mixing up expense patterns: Operating = straight-line; Finance = front-loaded
- Not identifying embedded leases: A contract may contain a lease even without being labelled as one
Quick Glossary
| Term | Plain-English Definition |
|---|---|
| ROU Asset | Right-of-Use Asset — represents the lessee’s right to use the leased property |
| Lease Liability | The obligation to make future lease payments, measured at present value |
| IBR | Incremental Borrowing Rate — rate the lessee would pay to borrow a similar amount |
| Finance Lease | A lease that transfers substantially all risks and rewards (previously "capital lease") |
| Operating Lease | A lease where the lessor retains most risks/rewards; straight-line expense under ASC 842 |
Frequently Asked Questions
What is a right-of-use asset under ASC 842?
A right-of-use (ROU) asset represents the lessee's right to use the underlying asset for the lease term. It is initially measured at the present value of lease payments plus any initial direct costs, prepayments, and less any lease incentives received.
How does ASC 842 differ from IFRS 16?
The biggest difference is that ASC 842 maintains a dual model (finance and operating leases with different expense patterns), while IFRS 16 uses a single model where all leases are treated similarly to finance leases with front-loaded expenses.
What is the short-term lease exemption?
Under ASC 842, leases with a term of 12 months or less (with no purchase option the lessee is reasonably certain to exercise) may be excluded from balance sheet recognition. This is elected as an accounting policy by class of underlying asset.
What discount rate should be used for ASC 842?
Use the rate implicit in the lease if it can be readily determined. If not, use the lessee's incremental borrowing rate (IBR), which is the rate the lessee would have to pay to borrow on a collateralised basis over a similar term.
Do operating leases still exist under ASC 842?
Yes. Unlike IFRS 16, ASC 842 retains the operating lease classification. Operating leases are now recognised on the balance sheet but retain straight-line expense recognition on the income statement, unlike finance leases which have front-loaded expenses.
CPA FAR Exam: How Lease Accounting Is Tested
| Exam Focus Area | What to Know |
|---|---|
| Classification criteria | Know the 5 finance lease criteria; if none met = operating |
| ROU asset measurement | PV of payments + initial direct costs + prepayments - incentives |
| Journal entries | Record commencement, payments, and expense entries for both types |
| Expense patterns | Operating = straight-line; Finance = front-loaded |
| Short-term practical expedient | When and how to apply the 12-month exemption |
Also see our related CPA FAR guides on LIFO vs FIFO, Deferred Tax Assets, and Revenue Recognition (ASC 606).
Ready to Pass CPA FAR?
Master lease accounting and every other FAR topic with structured CPA review materials.
Explore Surgent CPA Review Explore DipIFR CoachingAbout the Author
Vicky Sarin is the founder of Eduyush, a professional certification coaching platform. With years of experience in accounting education, Vicky helps CPA, ACCA, and DipIFR candidates master complex topics through clear, exam-focused content. Connect with Eduyush for CPA review courses and DipIFR coaching.
Leave a comment