Understanding the Tax Implications of ASC 842 in Lease Accounting

Practical Insights for Companies

The Financial Accounting Standards Board (FASB) introduced ASC 842. It has fundamentally changed how companies recognize leases on their financial statements. Before, leases were split into capital and operating leases, and only capital leases appeared on the balance sheet.

ASC 842 requires most leases to be recorded as both a right-of-use (ROU) asset and a corresponding liability. The ROU asset represents the lessee's right to use the underlying asset for the lease term (ASC 842 Glossary; recognized under ASC 842-20-25-1). Short-term leases are the exception, because a lessee may elect not to recognize them (ASC 842-20-25-2).

This shift has brought major tax implications. It affects deferred taxes, taxable income, and financial ratios, and these can heavily influence business decisions.

Companies adapting to ASC 842 need to understand these tax implications. They also need to understand the potential impact on cash flow, financing, and strategy. Here’s a closer look at the key areas ASC 842 affects. Each one has an example of the change and actionable steps to help mitigate the tax impacts effectively.

Deferred Tax Assets and Liabilities

ASC 842 contains no income tax guidance, as KPMG's Handbook: Leases (section 10) points out. Deferred taxes on leases are an ASC 740 matter (ASC 740-10). Topic 740 also governs how they are presented and disclosed.

Under ASC 842, companies record both ROU assets and lease liabilities (ASC 842-20-25-1). This creates new book-tax differences. The result is deferred tax assets (DTAs) and deferred tax liabilities (DTLs).

A DTA is a future deductible amount, and a DTL is a future taxable amount. Both are ASC 740 balances, not ASC 842 ones (ASC 740-10; KPMG Handbook: Leases, section 10.1).

Suppose a retail company has many store leases. It used to recognize these leases as operating expenses on the income statement. Now, under ASC 842, the ROU assets and lease liabilities appear on the balance sheet.

That creates a temporary difference between the book value and the tax basis of these assets and liabilities. Because of this difference, the company must recalculate its deferred tax positions each period (ASC 740-10).

New DTAs and DTLs can affect financial metrics like debt-to-equity ratio and return on assets (ROA). An operating lease creates both a deferred tax liability on the ROU asset and a deferred tax asset on the lease liability. The two are of similar size (ASC 740-10; see the lessee example in KPMG's Handbook: Leases, section 10.1).

Deloitte's Roadmap: Leases, section 13.3 notes these are "separate and distinct deferred tax amounts that generally should not be netted in the income tax disclosures". So both appear gross. But the leverage a lender sees comes from the lease liability, not from the deferred taxes. That could affect credit ratings and how investors see the company.

Because the leverage comes from the lease liability itself, what to do about it is a question for the company's advisers.

Changes in Taxable Income Calculations

ASC 842 affects the timing and method of lease expense recognition. For book purposes, an operating lease produces a single lease cost. It is allocated over the lease term on a straight-line basis, unless another systematic and rational basis is more representative of the pattern of benefit (ASC 842-20-25-6). A finance lease does not produce a single cost.

In a finance lease, the lessee recognizes amortization of the ROU asset and interest on the lease liability separately (ASC 842-20-25-5). So book expense is front-loaded. Either pattern may differ from the timing of deductions for tax purposes. The result can be differences in taxable income.

A manufacturing company leases equipment with fixed monthly payments. For financial reporting, it treats the lease as an operating lease and records the lease cost on a straight-line basis (ASC 842-20-25-6). For most conventional leases, Grant Thornton's Key tax impacts from the new leasing standard notes that taxpayers "usually deduct rent by following the payment schedule".

Leases with stepped, prepaid or deferred rent and total payments above $250,000 can fall under Section 467, which overrides that general rule. That is worth checking with your tax advisers before assuming cash-basis deductions. This timing difference can lead to temporary income differences.

These differences may push a company into a higher effective tax rate. They may also lead to unexpected tax liabilities. Higher book-tax differences can make tax planning harder. That is especially true for companies with large lease portfolios.

Some variable lease payments are not included in the lease liability. For an operating lease, those are recognized in the period the obligation is incurred (ASC 842-20-25-6(b)), so they change the book pattern. Whether they change the tax deduction is a separate question for the company's tax advisers.

Impact on Lease Classification and Tax Treatment

ASC 842 puts most leases on the balance sheet. But Deloitte's Roadmap: Leases, section 13.3 says: "A lease's classification for accounting purposes does not affect its classification for tax purposes."

KPMG's Handbook: Leases (section 10.3) adds that the change in book pattern can still prompt a company to consider whether a tax accounting method change is appropriate. The result is dual reporting requirements. These can add administrative complexity.

A company leases a fleet of delivery vehicles. For financial reporting, this lease is classified as a finance lease. So the company recognizes amortization of the ROU asset and interest on the lease liability (ASC 842-20-25-5). For tax purposes it may still be a true lease, with deductions based on the rent paid.

Differences between book and tax treatment add to the burden of tracking leases. This is especially so for companies with large portfolios. The differences may also create unexpected tax variances.

A lease short enough for the short-term election can stay off the balance sheet. In that case, no new ROU-asset or lease-liability basis difference arises. The election is made by class of underlying asset (ASC 842-20-25-2).

Beyond that, how a renegotiated lease is treated for tax is a question for the company's tax advisers. Grant Thornton's Key tax impacts from the new leasing standard notes a modification can pull a lease into Section 467.

Worked example: deferred tax on an operating lease

The numbers below show how the two deferred tax balances move on one small operating lease. This is an illustration, not tax guidance. The book side follows ASC 842. The deferred taxes follow ASC 740 (ASC 740-10).

The tax treatment here is an assumption made for the example. How a lease is characterized and deducted for tax is a question for the company's tax advisers.

• The lease is an operating lease with a three-year term.
• Rent is paid at the end of each year: $100,000, then $110,000, then $120,000.
• The discount rate is 6%.
• There are no initial direct costs, lease incentives or prepaid rent.
• The tax rate is 25%.
• For tax, the lease is assumed to be a true lease, and the rent is assumed to be deducted as it is paid.
• The ROU asset and the lease liability are each assumed to have a tax basis of zero.
• No valuation allowance is assumed on the deferred tax asset.

One caution on the tax assumption. This lease has stepped rent and total payments of $330,000. As noted earlier on this page, a lease like that can fall under Section 467, which may change when the rent is deducted. The example sets that aside to keep the arithmetic simple.

The lease liability starts at the present value of the payments not yet paid (ASC 842-20-30-1). Discounted at 6%, the three payments are worth $94,340, $97,900 and $100,754 today. That totals $292,994.

There are no initial direct costs, incentives or prepaid rent. So the ROU asset starts at the same $292,994 (ASC 842-20-30-5).

An operating lease produces a single lease cost, recognized here on a straight-line basis (ASC 842-20-25-6(a)). Total payments are $330,000 over three years. So the book lease cost is $110,000 a year.

After commencement, the liability is the present value of the remaining payments (ASC 842-20-35-3(a)). In practice, it grows by 6% of its opening balance each year and falls by the rent paid. That accretion is part of the single lease cost, not a separate interest expense.

The ROU asset is the closing liability less the cumulative accrued rent (ASC 842-20-35-3(b)). Accrued rent is book lease cost recognized ahead of the cash paid. The deferred tax asset is the closing liability times 25%. The deferred tax liability is the closing ROU asset times 25% (ASC 740-10).

Amounts are rounded to whole dollars. A roll-forward of the rounded figures can be off by a dollar. The net column is there to make the pattern visible. The two balances are separate temporary differences, and Deloitte's Roadmap: Leases (13.3, Income Taxes) says they generally should not be netted in the income tax disclosures.

Both deferred tax balances arise at commencement, and they are equal. Each is $292,994 times 25%, or $73,248. The net is zero on day one.

In year 1 the book cost is $110,000 and the cash rent is $100,000. The extra $10,000 is accrued rent. It pulls the ROU asset $10,000 below the liability. So the deferred tax asset exceeds the deferred tax liability by $10,000 times 25%, or $2,500.

That is the pattern to remember. In this example the net deferred tax asset always equals the accrued rent times the tax rate. In year 2 book cost equals cash rent, so the net stays at $2,500.

In year 3 the cash rent is $120,000 against a book cost of $110,000. The accrued rent reverses. The liability, the ROU asset and both deferred tax balances all end at zero. KPMG's Handbook: Leases (section 10.1) works a similar lessee example.

Interest Expense Deduction Limitation (Section 163(j))

Section 163(j) limits the deduction of business interest. Grant Thornton's Key tax impacts from the new leasing standard describes the limit as the sum of business interest income, 30% of adjusted taxable income (ATI) and floor-plan financing interest. How ATI is computed has changed more than once. Grant Thornton's article on the OBBBA changes to Section 163(j) says it changed again under OBBBA for tax years beginning after Dec. 31, 2024.

A book finance lease does not by itself create interest for tax. On the book side, the lessee recognizes interest on the lease liability (ASC 842-20-25-5). Grant Thornton notes that the book interest on a GAAP finance lease "is not interest for federal income tax purposes if the lease is a true lease for tax".

It adds that whether a lease is a financing for tax "does not automatically match the GAAP (or IFRS) treatment". Whether Section 163(j) bites depends on the tax characterization, not the book classification. That is a question for your tax advisers.

A tech company has finance leases on costly equipment. Its books show large interest expense on the lease liabilities (ASC 842-20-25-5). The company should not assume that this book interest is interest for tax. Whether Section 163(j) applies depends on how each lease is characterized for tax.

Restricted interest deductions may lead to higher taxable income and a higher tax liability. Whether a lease adds to that depends on its tax characterization, not its book classification.

Before changing lease terms to manage Section 163(j), a company should ask its tax advisers how each lease is characterized for tax.

State Tax Considerations

State tax rules vary in how closely they conform to federal tax standards. That adds complexity for multi-state operations under ASC 842.

A healthcare organization operates across several states. It may see its state apportionment change. In some states, the property factor is computed on the GAAP basis of property. In those states, the ROU asset can now enter that factor (Grant Thornton's Key tax impacts from the new leasing standard; KPMG Handbook: Leases, section 10.2).

Higher lease liabilities and ROU assets may alter state tax calculations. That could raise state tax burdens for multi-state organizations.

State effects generally run through the apportionment factors rather than through where a lease is administered. Section 10.2 of KPMG's Handbook: Leases puts it this way. "Entities generally should not assume that taxable or deductible amounts related to temporary differences in a tax jurisdiction will be shifted to a different tax jurisdiction through future intercompany transactions." Where leases change the property factor is a question for state tax specialists.

Tax Planning Opportunities and Strategic Adjustments

ASC 842 introduces challenges. It also raises questions worth taking to your tax advisers.

A construction company leases heavy machinery. It may look at shorter terms or variable payments. Whether that changes the deferred tax position depends on the combination of book and tax classification (ASC 740-10). See the lessee classification table at section 10.1 of KPMG's Handbook: Leases.

Classification is fixed at commencement. It is reassessed only when a contract is modified, or when the lease term or a purchase-option assessment changes (ASC 842-10-25-1). It is not something a company elects. Renegotiating a lease can change the classification, but Grant Thornton's Key tax impacts from the new leasing standard notes a modification can also pull a lease into Section 467.

Restructuring or buying changes which deduction a company gets. Under a true tax lease, the lessee deducts the rent. A company that owns the asset, or holds it under a non-tax lease, deducts depreciation instead (KPMG's Handbook: Leases, section 10.1). Which one applies is a tax question, not an ASC 842 one.

Companies sometimes look at purchasing critical assets, or at restructuring leases. Whether either changes the deferred tax position depends on the combination of book and tax classification (ASC 740-10; KPMG's Handbook: Leases, section 10.1). That is a question for the company's tax advisers.

Considerations for International Operations

Multinational companies face added complexity in managing lease accounting across jurisdictions. Each country’s tax laws differ.

A global company has leased properties in multiple countries. A group reporting under both ASC 842 and IFRS 16 carries two expense patterns. Grant Thornton's leasing tax article notes that lessees under IFRS 16 "must report all leases as finance leases, which may create new book/tax differences on the tax return". ASC 842 itself keeps two lessee models, finance and operating (ASC 842-20-25-5 and 842-20-25-6).

International operations may face differences in deferred tax treatment across jurisdictions. That makes tax compliance and reporting harder.

Multinational companies can centralize international lease management and develop streamlined internal policies. Both steps can help them reconcile ASC 842 with varying jurisdictional standards.

Actionable Steps by Organizational Role

Each role within the organization has responsibilities to help manage ASC 842 tax implications:

The CFO should work with tax and finance teams to assess ASC 842 impacts on tax and financial metrics. This includes overseeing any renegotiation of lease terms. Lease classification is not something a company elects. It is reassessed only when a contract is modified, or when the lease term or a purchase-option assessment changes (ASC 842-10-25-1).

The Tax Manager plays a key role in updating tax provisions and recalculating deferred taxes (ASC 740-10). The Tax Manager also coordinates with the accounting team to align tax reporting with ASC 842.

The Controller ensures leases are classified and accounted for properly. The Controller also works with tax professionals and documents book-tax differences for streamlined reporting.

IT ensures accounting systems reflect ASC 842 requirements. It also enables data integration for accurate tax reporting.

In Summary

ASC 842 fundamentally changes lease accounting. It brings new tax implications that affect business decisions and strategy. With careful planning and teamwork, companies can navigate ASC 842 effectively.

The book treatment and the tax treatment stay separate tracks. The tax outcome turns on how each lease is characterized for tax (ASC 740-10), not on its ASC 842 classification. That characterization is a question for the company's tax advisers.

Explore how iLeasePro can streamline your lease portfolio management!

Tour of iLeasePro

Schedule a Demo

Check Out Knowledge Base

If this guide proved beneficial, please share it with fellow colleagues or bookmark it for future reference. Keep an eye out for more deep dives into the intricate world of lease accounting and corporate taxes and how the ASC 842 Lease Accounting Standard impacts them.