Lease Accounting
The GAAP framework for recording lease agreements on financial statements, governed by ASC 842 for US companies.
What is Lease Accounting?
Lease accounting refers to the rules governing how companies record and report lease agreements in their financial statements. The current US standard, ASC 842 (effective for public companies from 2019), requires lessees to recognize a right-of-use asset and a corresponding lease liability on the balance sheet for virtually all leases with terms exceeding 12 months. Leases are classified as either finance leases (formerly called capital leases) — where the lessee recognizes amortization and interest expense separately — or operating leases, where a single straight-line expense is recognized. The standard was introduced to eliminate the practice of hiding significant lease obligations off the balance sheet, improving transparency for investors and creditors.
Example
A retailer signs a 10-year store lease with annual payments of $500,000. Under ASC 842, the retailer calculates the present value of all lease payments using its incremental borrowing rate. If the present value is $3.8 million, the retailer records a $3.8 million right-of-use asset and a $3.8 million lease liability on the balance sheet at commencement. Under operating lease treatment, annual rent expense of $500,000 is recognized straight-line over the 10-year term. This treatment can materially increase a retailer's reported total assets and liabilities.
Source: FASB — ASC 842: Leases