On the balance sheet, a lease is both an asset and a liability. When a business signs a lease that runs longer than 12 months, U.S. accounting rules require it to record a right-of-use asset for the right to use the property and a lease liability for the obligation to make future payments. Both entries appear from day one, and both stay on the books until the lease ends.
Why a Lease Produces Two Entries
Signing a lease gives your business two things at once. It gives you guaranteed access to property or equipment for a defined period, which has value. It also commits you to a stream of future payments, which is an obligation. Modern accounting recognizes both.
Before ASC 842 took effect, most leases sat off the balance sheet entirely. Companies recorded monthly rent as an expense and disclosed the future commitments in a footnote. The Financial Accounting Standards Board and the International Accounting Standards Board changed that because investors and regulators argued the old treatment let businesses carry enormous obligations without showing them as liabilities.1Financial Accounting Standards Board. IASB and FASB Propose Changes to Lease Accounting Public companies had to adopt the new approach for fiscal years beginning after December 15, 2018. Private companies followed for fiscal years beginning after December 15, 2021.2KPMG. No Additional ASC 842 Deferral for Private Entities
The Right-of-Use Asset
The asset recorded is not the building or the truck itself. It is the contractual right to use that building or truck for the lease term. If your company signs a seven-year office lease, those seven years of guaranteed access are what sit on the balance sheet, alongside owned property and equipment.
The starting value of the right-of-use asset is not simply the sum of your future rent checks. It begins with the lease liability amount, then adjusts for a few items: any lease payments made before the lease started, any initial direct costs like broker commissions paid to obtain the lease, and any landlord incentives, which reduce the asset value.3DART – Deloitte Accounting Research Tool. 6.11 Initial Direct Costs Legal fees and tax advice tied to negotiating the lease do not count as initial direct costs under ASC 842. Only truly incremental costs, ones that would not have been incurred if the lease had never been signed, qualify.
The Lease Liability
The lease liability is the present value of the future payments you owe at the start of the lease. Present value matters because a dollar owed five years from now is worth less than a dollar owed today. Each future payment is discounted back to today’s dollars using an appropriate interest rate. The payments that go into the calculation include fixed rent, amounts you expect to pay under residual value guarantees, and the price of any purchase option you are reasonably certain to exercise.
As you make payments, part of each one reduces the liability and part is treated as interest expense on the outstanding balance. The liability shrinks over time, the way a mortgage balance decreases with each monthly payment. That is why lenders and credit rating agencies treat lease obligations seriously when they evaluate a company’s financial health.
The Discount Rate Matters
The rate used to discount future payments moves both the asset and the liability. ASC 842 says to use the rate implicit in the lease when it can be determined, meaning the rate the lessor used to price the deal. Lessees rarely know that rate in practice. When it is not available, you use your incremental borrowing rate, which is the interest rate you would pay to borrow a similar amount, on a collateralized basis, over a similar term.4DART – Deloitte Accounting Research Tool. 7.1 General A higher discount rate produces a smaller liability. A lower rate produces a larger one.
Finance Leases and Operating Leases Both Hit the Balance Sheet
Both types of leases produce a right-of-use asset and a lease liability. The difference between them shows up on the income statement, in how the expense is recognized. Classification depends on whether the lease is really a disguised purchase or a straightforward rental.
Under ASC 842, a lease is a finance lease if it meets any one of five criteria:5DART – Deloitte Accounting Research Tool. 9.2 Lease Classification
- The lease transfers ownership of the property to you by the end of the term.
- You have a purchase option you are reasonably certain to exercise.
- The lease covers a major part of the property’s remaining economic life.
- The present value of your payments equals or exceeds substantially all of the property’s fair value.
- The property is so specialized that the lessor has no practical alternative use for it after the lease ends.
If none apply, the lease is an operating lease. Most office and retail space leases fall on the operating side. Equipment leases that run close to the asset’s full useful life often land on the finance side.
For a finance lease, you record two separate expenses: amortization of the right-of-use asset and interest expense on the lease liability. Amortization is typically straight-line over the shorter of the asset’s useful life or the lease term.6Viewpoint. 4.4 Subsequent Recognition and Measurement – Lessee Because interest is front-loaded, total expense is higher in the early years. For an operating lease, you record a single straight-line lease expense across the term. The total cost is the same either way; only the timing differs.
If your company reports under IFRS rather than U.S. GAAP, the finance-operating distinction largely disappears for lessees. IFRS 16 uses a single model where every lease is treated in a manner similar to a finance lease under ASC 842.
When a Lease Stays Off the Balance Sheet
Not every lease has to appear as an asset and a liability. ASC 842 provides an exemption for short-term leases, defined as those with a term of 12 months or less at the start date that do not include a purchase option you are reasonably certain to exercise.7KPMG. Hot Topic: ASC 842 – Understanding the Short-Term Lease Exemption If you elect the exemption, you skip the right-of-use asset and lease liability entirely and record the payments as expense on a straight-line basis.8DART – Deloitte Accounting Research Tool. 8.2 Policy Decisions That Affect Lessee Accounting
The election is made by class of underlying asset, not lease by lease. You could elect it for all short-term equipment leases and not for short-term vehicle leases. Even when you take the exemption, you still disclose short-term lease expense in the footnotes. A lease that extends even one day beyond 12 months does not qualify.
What Changes on the Balance Sheet and Beyond
Putting lease liabilities on the balance sheet moves the numbers investors and lenders use to evaluate a company. The debt-to-equity ratio rises because total liabilities grow. Return on assets can decline because total assets expand while net income stays roughly the same. For companies with heavy lease exposure, including airlines, retailers, and restaurant chains, the shifts have been sizable.
Loan covenants are a practical concern. Many commercial lending agreements include financial ratio tests, and the sudden appearance of new liabilities could technically trigger a default. This has been less disruptive than feared. Many existing loan agreements include frozen GAAP clauses that prevent accounting standard changes from triggering covenant violations. ASC 842 also classifies operating lease liabilities as operating liabilities rather than debt, which means they may not factor into certain covenant calculations at all. Credit rating agencies had already been adjusting for off-balance-sheet leases in their models for years, so the new standard brought public reporting closer to what they were calculating internally.
If you are negotiating new financing, expect lenders to look closely at your lease portfolio.
Who These Rules Apply To
ASC 842 governs entities that report financial statements under U.S. GAAP. By now, every company reporting under GAAP should be in compliance.
These rules do not apply to individuals. If you lease a car or rent an apartment, you are not preparing GAAP financial statements, and you do not record a right-of-use asset on a personal balance sheet. Your car lease still works like a liability in the personal-finance sense because it commits you to future payments, and lenders factor that obligation into your debt-to-income ratio when you apply for a mortgage. The formal dual-entry treatment described above is a corporate and organizational reporting requirement, not a personal one.