US GAAP Operating Lease Accounting: A Guide to ASC 842 (Lessee Perspective)

Introduction

Operating leases have long been a common mechanism for companies to access and use assets without owning them outright. Historically, many of these leases were kept off the balance sheet, limiting transparency for investors, creditors, and other stakeholders. To address this, the Financial Accounting Standards Board (FASB) issued ASC 842, which requires lessees to recognize nearly all leases on the balance sheet, providing a clearer view of a company’s leasing obligations and overall financial position (Barker et al., 2016).

ASC 842 represents a significant shift from the previous standard, requiring lessees to measure and record a lease liability for future lease payments and a corresponding right-of-use (ROU) asset. The standard also introduces a streamlined approach for presenting lease expenses in the income statement and clarifies reporting and disclosure requirements. Its overarching goal is to enhance transparency, reduce off-balance-sheet financing, and align U.S. GAAP more closely with global reporting practices, though notable differences remain compared to IFRS 16 (Barker et al., 2016).

This blog focuses on the lessee perspective under ASC 842. It will guide readers through the accounting process for operating leases, from initial recognition to subsequent measurement. Through a detailed example, we will illustrate how lease liabilities and ROU assets are calculated, how lease expenses are recognized consistently in the income statement, and how the balance sheet reflects these transactions. By the end of this discussion, readers will gain the understanding of ASC 842 and its implications for financial reporting and decision-making.

Accounting For Operating Lease - Initial Recognition

Finance Lease vs. Operating Lease

According to BDO (2025), the accounting process for a finance lease and an operating lease is the same in the following areas:

• How the lease liability is first recognized and calculated.

• How the right-of-use asset is first recognized and calculated.

• How the lease liability is measured and updated after the initial recognition.

However, there are key differences in how these leases are accounted for after the initial setup:

• The way the right-of-use asset is amortized (spread out as an expense) over time.

• How the interest expense and asset amortization are presented on the income statement.

• How the lease payments are classified in the statement of cash flows.

Initial Recognition

Journal Entry at the Lease Commencement Date

When a lease begins, the company must record the right to use the asset and the obligation to pay for it. The journal entry is:

• Debit: Right-of-Use Asset (ROUA)

• Credit: Lease Liability (Present Value of Future Lease Payments)

Lease Liability for Lessee - Initial Recognition

A lease liability is a key part of the accounting entry. On the day the lease starts, this liability is calculated as the present value of all the lease payments that will be made during the lease term.

To find this present value, you need a discount rate. The rules specify which rate to use:

1. First, use the interest rate built into the lease (the implicit rate), if known to the lessee

2. When the implicit rate is not known, the lessee applies its incremental borrowing rate the rate it would pay to borrow over a similar term for a similar amount (PwC, 2025; BDO, 2025).

Present Value (PV) of Lease Payments

To calculate the lease liability, you must find the total present value of several future payments. This includes:

1. The present value of all the fixed rental payments to be made during the lease term.

2. The present value of any amount the lessee will probably have to pay for a residual value guarantee.

Example:
Suppose a lessee enters into a lease agreement and guarantees that the leased asset will have a minimum value of $60,000 at the end of the lease term. At the beginning of the lease, the lessee estimates that the asset’s residual value will only be $45,000. As a result, it is likely that the lessee will need to pay the lessor $15,000 to meet the guaranteed minimum value.

It is important to note that this guarantee serves two distinct purposes:

Lease Classification (Assessment):
When determining whether the lease is a finance lease or an operating lease, the full guaranteed amount of $60,000 is considered. This ensures that the test for whether the lease transfers “substantially all” of the risks and rewards of the asset is accurate.

Liability Measurement (Recording):
For the initial calculation of the lease liability on the balance sheet, only the expected payment of $15,000 is included. This reflects the lessee’s actual anticipated obligation under the guarantee.

3. Present Value of Early Termination Penalties:
   If a lease includes an option to end it before the full term, any expected penalty must be included in the lease liability.

Example:
Imagine you enter a 6-year office lease but have the option to terminate after 4 years by paying a $20,000 penalty. You reasonably expect to exercise this early termination option.

Accounting Treatment:
In this case, the lease term is considered to be 4 years. To calculate the initial lease liability, you include both the present value of the 4 years of rent and the present value of the $20,000 termination penalty.

Calculating the Lease Liability

The total lease liability is calculated by adding together the present values of several future payments:

1. Present Value of Lease Rentals:
   (Annual Rental Amount × Relevant Annuity Factor) = XXX

Plus

2. Present Value of the Residual Value Guarantee owed by the Lessee:
   (Guaranteed Amount the lessee will probably owe × Relevant Present Value Factor) = XXX

Plus

3. Present Value of a Non-Renewal Penalty
   (Penalty Amount × Relevant Present Value Factor) = XXX

Right-of-Use (ROU) Asset – Initial Recognition

At the Start of the Lease:
The ROU asset is recognized on the lease commencement date. Its value is based on the lease liability plus any initial direct costs incurred by the lessee.

Examples of Initial Direct Costs:

• Commissions paid to brokers or real estate agents for securing the lease.

• Legal fees for negotiating lease agreements.

• Costs of internal legal services directly related to the lease (BDO, 2025).

Measurement:
The ROU asset is calculated as the total lease liability recognized initially, plus any initial direct costs the lessee paid to obtain the lease.

No Initial Direct Costs:
If the lessee did not incur any direct costs, the ROU asset will equal the initial lease liability.

Lease Accounting Example: Operating Lease Initial Recognition and Subsequent Measurement

Question

On January 1, Year 1, SilverTech Ltd. entered into a 3-year lease for machinery from Alpha Equipment LLC. The machinery has a total useful life of 5 years. SilverTech has determined this lease qualifies as an Operating Lease under US GAAP (ASC 842).

The rental payment schedule is as follows:

• $110,000 at the end of Year 1

• $110,000 at the end of Year 2

• $160,000 at the end of Year 3

SilverTech does not know the interest rate implicit in the lease, so it uses its incremental borrowing rate of 14%.

Present value factors:

• PV of $1 at 14% for 1 year: 0.87719

• PV of $1 at 14% for 2 years: 0.76947

• PV of $1 at 14% for 3 years: 0.67556

Solution

The lease liability and right-of-use (ROU) asset are initially recognized at the present value of all future lease payments.

Step 1: Initial Recognition of Lease Liability and ROU Asset

Calculation of Present Value of Lease Payments:

1. Year 1 Payment PV:
   $110,000 × 0.87719 = $96,491

2. Year 2 Payment PV:
   $110,000 × 0.76947 = $84,642

3. Year 3 Payment PV:
   $160,000 × 0.67556 = $108,090

4. Total Present Value (Initial Recognition):
   $96,491 + $84,642 + $108,090 = $289,223

Journal Entry at Lease Commencement (January 1, Year 1)

Date                    Account                                    Debit              Credit
Jan 1, Year 1        Right-of-Use (ROU) Asset        $289,223
                            Lease Liability                                                   $289,223

Step 2: Subsequent Measurement – Lease Liability Amortization

After the lease begins, each payment the lessee makes has two parts:

1. Interest Expense: The cost of financing the lease for the period.

2. Reduction of the Lease Liability: The part of the payment that pays down the principal balance.

Important Timing Note:
If the first lease payment is made right on the lease start date, the entire payment goes toward reducing the lease liability. No interest expense is recorded because no time has passed for interest to build up.

How to Calculate Interest Expense:
Interest expense is calculated using the effective interest method. The formula is:

Interest Expense = Lease Liability at the Beginning of the Period × Discount Rate

Lease Amortization Schedule

The rounding difference of $140 arises because interest and principal amounts are rounded to the nearest dollar each period, resulting in a small residual that is adjusted in the final payment.

Step 3: Income Statement – Straight-Line Lease Expense

Under US GAAP, operating leases are presented more simply on the income statement. A single, consistent lease expense is recognized in each reporting period of the lease term (PwC, 2025).

Formula:
Single Periodic Lease Expense = (Total Undiscounted Lease Payments + Initial Direct Costs) ÷ Lease Term

Calculations of Lease Expense:

Total lease payments:
110,000 + 110,000 + 160,000 = 380,000

Annual straight-line lease expense:
380,000 / 3 = 126,667 per year

ROU Asset Amortization per Year

Step 4: Balance Sheet – ROU Asset & Lease Liability

ROU Asset Carrying Value

(Rounding differences adjusted in final year.)

Lease Liability Classification (End of Year 1):

• Current: $79,240

• Non-current: $140,474

• Total: $219,714

Step 5: Income Statement – Lease Expense

Step 6: Journal Entries

January 1, Year 1 – Initial Recognition

Account                                                             Debit                 Credit
Right of Use Asset                                             289,223 
Lease Liability                                                                               289,223

December 31, Year 1 – Payment & Amortization

Account                                                            Debit                   Credit
Lease Expense                                                  126,667 
Lease Liability                                                    69,509 
Right-of-Use Asset                                                                        86,176
Cash                                                                                              110,000

(Entries for Years 2–3 follow the same pattern.)

Conclusion: Understanding Operating Lease Accounting under ASC 842

The implementation of ASC 842 has fundamentally transformed how companies account for operating leases. The previous practice of keeping leases off the balance sheet is now largely eliminated, ensuring nearly all leases are recognized and providing stakeholders with a transparent view of a company’s leasing obligations.

From the lessee perspective, accounting under ASC 842 involves three key steps:

1. Initial Recognition: Record the lease as both a Right-of-Use (ROU) Asset and a Lease Liability, measured at the present value of future lease payments.

2. Subsequent Measurement:

   • The lease liability is amortized using the effective interest method, resulting in front-loaded interest expense.

   • The ROU asset is amortized so that, combined with interest, the total lease expense is recognized on a straight-line basis in the income statement.

3. Financial Statement Presentation: The balance sheet reflects the evolving values of both the asset and liability, the income statement shows a consistent lease expense, and the cash flow statement appropriately classifies lease payments.

Key Takeaway for Practitioners:
While ASC 842 introduces complexity, it enhances transparency and provides a clearer, more accurate picture of a company’s leasing commitments, supporting better financial reporting and decision-making.

Disclaimer:
This blog is intended for educational purposes only. The content reflects the author’s understanding of US GAAP ASC 842 for operating leases (lessee perspective) and is not a substitute for professional accounting advice.

References

Barker, J., Farber, T., McKinney, S. & Kolber, T. (2016) FASB’s new standard brings most leases onto the balance sheet. Heads Up, 23(5). Deloitte & Touche LLP. Available at:
[Accessed 2 November 2025].

BDO (2025) Accounting for leases under ASC 842: Chapter 5 – Accounting for leases – lessee. BDO Blueprint Series. Available at:
[Accessed 2 November 2025].

PwC (2025) 14.4 Lessee accounting – classification. Available at:
[Accessed 22 October 2025].