Operating Leases Explained (Lessees) - ASC 842

Operating Lease Recognition

Under ASC 842, lessees recognize operating leases by recording a right-of-use asset and a corresponding lease liability on the balance sheet at the lease commencement date. The lease liability represents the present value of future lease payments, while the right-of-use asset represents the lessee's right to use the underlying asset over the lease term.

This recognition requirement applies to all operating leases except those qualifying for the short-term lease recognition exemption (leases with a term of 12 months or less).

Despite the balance sheet recognition, operating leases continue to produce straight-line expense recognition in the income statement, maintaining the expense pattern familiar from ASC 840. This distinguishes operating leases from finance leases, which result in front-loaded expense recognition with separate interest and depreciation components.

Operating vs Finance Lease Classification

Lessees must classify each lease as either an operating lease or a finance lease at the commencement date. A lease is classified as a finance lease if it meets any of the following five criteria:

Ownership transfer: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

Purchase option: The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

Lease term: The lease term is for the major part of the remaining economic life of the underlying asset (generally interpreted as 75% or more).

Present value: The present value of the sum of lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset (generally interpreted as 90% or more).

Specialized 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.

If none of these criteria are met, the lease is classified as an operating lease. The classification significantly impacts the expense recognition pattern and financial statement presentation.

We wrote a detailed article outlining finance leases vs. operating leases for lessees under ASC 842.

Initial Measurement

At the commencement date, lessees measure both the lease liability and the right-of-use asset for operating leases. The lease commencement date is the date on which the lessor makes the underlying asset available for use by the lessee.

Key considerations at initial measurement:

The measurement requires determination of the lease payments to include, selection of an appropriate discount rate, assessment of the lease term (including options to extend or terminate), and evaluation of whether any payments represent lease or non-lease components.

Lessees must also determine whether any initial direct costs were incurred and whether any lease incentives were received or are receivable, as these affect the initial measurement of the right-of-use asset.

Lease Liability Calculation

The lease liability is measured at the present value of lease payments not yet paid at the commencement date, discounted using either the rate implicit in the lease or the lessee's incremental borrowing rate.

Lease payments included in the liability:

• Fixed payments: All fixed payments (including in-substance fixed payments), less any lease incentives paid or payable to the lessee.

• Variable payments based on index or rate: Variable lease payments that depend on an index (such as the Consumer Price Index) or a rate (such as SOFR), initially measured using the index or rate at the commencement date.

• Residual value guarantees: Amounts expected to be payable by the lessee under residual value guarantees.

• Purchase options: The exercise price of a purchase option if the lessee is reasonably certain to exercise that option.

• Termination penalties: Penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate.

Excluded payments:

Variable lease payments not based on an index or rate are excluded from the lease liability and expensed as incurred. Non-lease components can also be excluded if the lessee elects the practical expedient to combine lease and non-lease components, otherwise they are accounted for separately.

Discount rate:

Lessees should use the rate implicit in the lease if readily determinable. If not, they use their incremental borrowing rate, which is the rate of interest the lessee would pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.

Right-of-Use Asset Calculation

The right-of-use asset is measured at the commencement date as the sum of:

1. The initial measurement of the lease liability
2. Any lease payments made to the lessor at or before the commencement date, less any lease incentives received
3. Any initial direct costs incurred by the lessee

Initial direct costs are incremental costs that would not have been incurred if the lease had not been obtained. Under ASC 842, this is narrower than under ASC 840 and generally includes only costs such as commissions and payments made to existing tenants to obtain the lease.

Lease incentives reduce the right-of-use asset. Common lease incentives include cash payments from the lessor, reimbursement of lessee costs, and rent-free periods.

Subsequent Measurement

After the commencement date, lessees account for operating leases using a dual measurement approach:

Lease liability measurement:

The lease liability is measured by:

1. Increasing the carrying amount to reflect interest on the lease liability (using the effective interest method)
2. Reducing the carrying amount to reflect lease payments made

The interest rate used is the same discount rate determined at commencement (or at the most recent remeasurement date).

Right-of-use asset measurement:

The right-of-use asset is measured at cost less accumulated depreciation. The depreciation is calculated as the amount necessary to produce straight-line total lease expense when combined with the interest on the lease liability.

This means the depreciation of the right-of-use asset is not determined independently but is derived to achieve the straight-line expense objective. In early periods, when interest expense is higher, depreciation is lower. In later periods, when interest expense decreases, depreciation increases to maintain the constant total expense.

Straight-Line Lease Expense

Operating lease expense is recognized on a straight-line basis over the lease term, resulting in a single lease cost each period that combines the depreciation of the right-of-use asset and interest accretion on the lease liability.

Calculating straight-line expense:

The straight-line expense amount is calculated at lease commencement as:

Straight-Line Expense = Total Lease Payments ÷ Lease Term (in periods)

This calculation uses the same total lease payments included in the lease liability measurement. The resulting amount remains constant each period unless the lease is modified or remeasured.

Components creating straight-line expense:

Each period, the total operating lease expense comprises:

• Interest expense on the lease liability (calculated using the effective interest method)
• depreciation of the right-of-use asset (calculated as the difference between the total straight-line expense and the interest expense)

While these components vary from period to period, they always sum to the predetermined straight-line expense amount. This is achieved by adjusting the depreciation of the right-of-use asset to offset the declining interest expense over time.

Variable lease payments:

Variable payments not based on an index or rate are recognized as variable lease expense in the period incurred, separate from the straight-line base expense. Variable payments based on an index or rate are included in the initial measurement but may create additional expense (or income) when the index or rate changes, depending on the lease terms.

Practical Example

Scenario: A lessee enters into a 5-year operating lease for office equipment with the following terms:

• Lease commencement: January 1, 2026
• Lease term: 5 years (60 months)
• Monthly payments: $2,000 at the end of each month
• Lease incentive: $5,000 received at commencement
• Initial direct costs: $3,000 (broker commission)
• Incremental borrowing rate: 6% per annum (0.5% per month)
• No residual value guarantee, purchase option, or other variable payments

Step 1: Calculate lease liability

Present value of 60 monthly payments of $2,000 at 0.5% monthly rate:

PV = $2,000 × [(1 - (1.005)^-60) / 0.005] PV = $2,000 × 51.7256 Initial lease liability = $103,451

Step 2: Calculate right-of-use asset

Step 3: Calculate straight-line expense

Total lease payments = $2,000 × 60 months = $120,000 Straight-line expense = $120,000 ÷ 60 months = $2,000 per month

Step 4: Journal entry at commencement (January 1, 2026)

Dr Right-of-use asset           $101,451
Dr Prepaid rent (incentive)       $5,000
   Cr Lease liability                      $103,451
   Cr Cash (initial direct costs)            $3,000

Step 5: Subsequent measurement (Month 1 - January 31, 2026)

Month 1 journal entry:

Dr Operating lease expense      $2,000
   Cr Right-of-use asset                  $1,483
   Cr Lease liability                       $517

Dr Lease liability              $2,000
   Cr Cash                                $2,000

Lease liability after Month 1: $103,451 + $517 - $2,000 = $101,968

Right-of-use asset after Month 1: $101,451 - $1,483 = $99,968

Month 12 comparison (one year later):

As shown, the interest expense decreases over time while the depreciation increases, but the total expense remains constant at $2,000 per month throughout the lease term.

Lease Modifications

A lease modification is a change to the scope of a lease or the consideration for a lease that was not part of the original terms and conditions. Common modifications include extending or shortening the lease term, adding or removing the right to use additional assets, or changing lease payments.

Determining if a modification is a separate contract:

A modification is accounted for as a separate contract if both:

1. The modification grants the lessee an additional right of use not included in the original lease (e.g., the right to use an additional asset)
2. The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract

If these conditions are met, the modification is accounted for as a new lease separate from the original lease.

Accounting for modifications that are not separate contracts:

For operating lease modifications that do not qualify as separate contracts, the lessee:

1. Determines the revised lease payments based on the modified terms
2. Determines the revised lease term, reassessing options to extend or terminate
3. Remeasures the lease liability using a revised discount rate (determined at the modification date)
4. Adjusts the right-of-use asset by the amount of the remeasurement of the lease liability

The revised discount rate is the rate implicit in the lease for the remainder of the lease term or, if not readily determinable, the lessee's incremental borrowing rate at the modification date.

Subsequent expense recognition after modification:

After the modification, the lessee recalculates the straight-line expense prospectively based on:

• The modified lease liability plus any prepaid or accrued lease payments
• The remaining lease term from the modification date

Modification example:

A lessee has an operating lease with 3 years remaining, a lease liability of $30,000, and annual payments of $11,000. The parties agree to extend the lease by 2 years with annual payments of $12,000 for years 4-5. The incremental borrowing rate at modification is 5%.

Original straight-line expense: Total payments over original term

After modification:

• Remaining payments: $11,000 (Year 1) + $11,000 (Year 2) + $11,000 (Year 3) + $12,000 (Year 4) + $12,000 (Year 5) = $57,000
• New PV calculated at 5% over 5 years
• New straight-line expense calculated as total payments ÷ remaining term
• Recognition continues prospectively with new straight-line amount

Financial Statement Presentation

Operating leases must be presented appropriately across all financial statements, with specific disclosure requirements.

Balance sheet presentation:

• Right-of-use assets should be presented separately from other assets, or disclosed in the notes if not presented separately on the face of the balance sheet. Many lessees present a single line item "Operating lease right-of-use assets" within non-current assets.

• Lease liabilities should be presented separately from other liabilities, or disclosed in the notes. The liability is typically split between current (due within 12 months) and non-current portions.

Income statement presentation:

• Operating lease expense is presented as a single line item within operating expenses. Common presentations include:
  • Within cost of goods sold (for production-related leases)
  • Within selling, general and administrative expenses
  • As a separate line item "Operating lease expense"

The interest and depreciation components are not separately presented for operating leases, unlike finance leases where interest expense and depreciation are shown separately.

Cash flow statement presentation:

• Cash payments for operating leases are classified within operating activities. This treatment differs from finance leases, where principal payments are classified as financing activities.

Disclosure requirements:

ASC 842 requires extensive disclosures including:

• Qualitative and quantitative information about leases
• Weighted-average remaining lease term
• Weighted-average discount rate
• Maturity analysis showing undiscounted cash flows for each of the first five years and thereafter
• Reconciliation of undiscounted cash flows to the lease liability
• Operating lease expense recognized in each period
• Variable lease expense and short-term lease expense
• Supplemental cash flow information (such as right-of-use assets obtained in exchange for new operating lease liabilities)

Many organizations present a combined maturity analysis that includes both operating and finance leases, with separate columns for each type.

Conclusion

Accounting for operating leases under ASC 842 requires lessees to recognize both a right-of-use asset and lease liability on the balance sheet, while maintaining straight-line expense recognition in the income statement. Lessees must carefully determine lease payments to include in the liability, select appropriate discount rates, assess lease terms including options to extend or terminate, and account for modifications when lease terms change. Despite the complexity of the measurement mechanics, the objective remains clear: to faithfully represent the economic reality of the lessee's obligation to make lease payments and their right to use the underlying asset over the lease term.

For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.