Lease Accounting Under ASC 842: Lessee Accounting Explained
By SimplyCPA · 11 October 2026
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- Is there a lease?: A contract conveys the right to control the use of an identified asset for a period, in exchange for consideration.
- Balance sheet: Lessees recognise a right-of-use (ROU) asset and a lease liability for almost all leases longer than 12 months.
- Classification: Finance lease if any one of five tests is met — ownership transfer, a purchase option reasonably certain to be exercised, a major part of economic life, PV of payments substantially all of fair value, or a specialised asset.
- Expense pattern: Finance leases show amortisation plus interest (front-loaded); operating leases show a single straight-line lease cost.
- Ind AS and IFRS contrast: Ind AS 116 and IFRS 16 have no operating-lease category for lessees.
Step 1: does the contract contain a lease?
Under ASC 842, 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 means the customer has both the right to obtain substantially all of the economic benefits from use and the right to direct how and for what purpose the asset is used. If the supplier has a substantive right to substitute the asset, there's no identified asset — and no lease.
Step 2: initial measurement
- Lease liability = present value of lease payments not yet paid: fixed payments, variable payments based on an index or rate, purchase options reasonably certain to be exercised, termination penalties, and amounts probable of being owed under residual value guarantees.
- Discount rate = the rate implicit in the lease if readily determinable; otherwise the lessee's incremental borrowing rate. Entities that aren't public business entities may elect a risk-free rate.
- ROU asset = lease liability + payments made at or before commencement + initial direct costs − lease incentives received.
Step 3: classification ("OWNES")
| Test | Question |
|---|---|
| Option to purchase | Is the lessee reasonably certain to exercise a purchase option? |
| Whole ownership transfers | Does ownership pass to the lessee by the end of the term? |
| No alternative use | Is the asset so specialised that the lessor has no alternative use for it? |
| Economic life | Is the term a major part of the remaining economic life? (75% or more is a common benchmark) |
| Substantially all of fair value | Does the PV of payments plus any guaranteed residual equal substantially all of fair value? (90% or more is a common benchmark) |
Meet any one and it's a finance lease; meet none and it's an operating lease.
Step 4: subsequent measurement
| Finance lease | Operating lease | |
|---|---|---|
| Liability | Effective interest method | Effective interest method (PV of remaining payments) |
| ROU asset | Amortised, usually straight-line | Plug: straight-line lease cost − interest accretion on the liability |
| Income statement | Amortisation and interest shown separately | Single lease cost, straight-line |
| Cash flow statement | Principal: financing; interest: operating | All operating |
Worked example
A lessee signs a 3-year lease with annual payments of $10,000 in arrears at a 6% discount rate. Lease liability = $10,000 × 2.6730 = $26,730; ROU asset is the same.
| Year | Interest (6%) | Payment | Closing liability | Finance lease expense | Operating lease cost |
|---|---|---|---|---|---|
| 1 | $1,604 | $10,000 | $18,334 | $1,604 + $8,910 = $10,514 | $10,000 |
| 2 | $1,100 | $10,000 | $9,434 | $1,100 + $8,910 = $10,010 | $10,000 |
| 3 | $566 | $10,000 | $0 | $566 + $8,910 = $9,476 | $10,000 |
Total expense is $30,000 either way — only the timing differs.
Remeasurement and modifications
- The liability is remeasured when the lease term changes, the assessment of a purchase option changes, amounts under residual value guarantees change, or contingent variable payments become fixed. The ROU asset is adjusted by the same amount.
- A modification that adds a right to use an additional asset at its standalone price is a separate contract. Other modifications are remeasured at the modification date.
Practical expedients and exemptions
- Short-term leases (12 months or less, no purchase option reasonably certain to be exercised) may be kept off the balance sheet.
- Lessees may elect not to separate lease and non-lease components (such as maintenance) by asset class.
- Private companies may use the risk-free rate, and may account for leases between entities under common control using the written terms (ASU 2023-01).
Lessors in brief
Lessors classify leases as sales-type (derecognise the asset, record a net investment and possibly selling profit), direct financing (profit deferred into interest income) or operating (keep the asset, record straight-line lease income).
See our full FAR leases notes, and US GAAP vs Ind AS for how Ind AS 116 differs.