Lease Accounting Changes and What They Mean for Your Business

The world of business accounting has undergone its most significant shift in decades, and it directly impacts how you report your leases. The new standard, known as ASC 842, has fundamentally changed the rules, requiring most businesses to add previously hidden lease obligations to their balance sheets. For any company that leases real estate, equipment, or other assets, understanding the nuances of ASC 842 lease accounting is not just a matter of compliance-it is crucial for maintaining financial health and securing future funding. This guide will walk you through everything you need to know about these changes and how to navigate them successfully.

What is ASC 842? A Plain-English Explanation

ASC 842, also known as Accounting Standards Codification Topic 842, is the new lease accounting standard issued by the Financial Accounting Standards Board (FASB). Its primary goal is to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet. In simpler terms, FASB wanted to eliminate the problem of "off-balance-sheet financing" that was common under the old rules.

Before ASC 842, companies could sign long-term operating leases for significant assets-like office buildings, fleets of vehicles, or major equipment-without having to record those obligations on their primary financial statement, the balance sheet. These commitments were only disclosed in the footnotes of financial reports. This practice made it difficult for investors, lenders, and other stakeholders to get a true picture of a company's financial obligations and overall risk profile. A company could appear to have very little debt on its balance sheet while actually being committed to millions of dollars in future lease payments.

ASC 842 changes all of that. The new standard requires that companies recognize assets and liabilities for almost all leases, including those previously classified as operating leases. This means that for any lease with a term longer than 12 months, a company must record a "Right-of-Use" (ROU) asset, which represents its right to use the leased item, and a corresponding "Lease Liability," which represents its obligation to make lease payments. This move significantly alters the appearance of a company's balance sheet, often making it look larger and more leveraged than before.

ASC 842 vs. ASC 840: The Key Differences

The transition from the old standard, ASC 840, to the new ASC 842 represents a fundamental shift rather than a minor update. While both standards recognize two types of leases, the treatment of one of those types is drastically different. Here’s a breakdown of the most critical changes:

• Balance Sheet Recognition: This is the single biggest change. Under ASC 840, only capital leases (now called finance leases) were recorded on the balance sheet. Operating leases were kept off the balance sheet, with lease payments treated as a simple operating expense on the income statement. Under ASC 842, both finance leases and operating leases must be recognized on the balance sheet with an ROU asset and a lease liability.
• Lease Classification Criteria: The criteria for determining whether a lease is a finance lease (formerly capital lease) or an operating lease have been updated. ASC 842 provides five specific tests. If a lease meets any one of these five criteria, it is classified as a finance lease. If it meets none, it's an operating lease. This is slightly different from the four "bright-line" tests under ASC 840.
• Definition of a Lease: ASC 842 introduces a more explicit definition of a lease, focusing on the concept of "control." 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. This requires businesses to more carefully scrutinize service contracts and other agreements to identify "embedded leases" that might have been overlooked previously.
• Disclosure Requirements: The new standard demands more detailed qualitative and quantitative disclosures about leasing activities. Companies must provide extensive information about the nature of their leases, significant judgments made in applying the standard, and amounts recognized in the financial statements related to their leases. This is meant to give readers of financial statements a much clearer picture of the company's leasing exposure.

Who Needs to Comply with ASC 842?

The short answer is: almost every entity that leases assets. The ASC 842 standard applies to all companies, organizations, and not-for-profits that follow U.S. Generally Accepted Accounting Principles (GAAP). This includes:

• Public Companies: Public business entities were the first to adopt the new standard, with an effective date for fiscal years beginning after December 15, 2018.
• Private Companies: After several delays, the standard became effective for private companies and private not-for-profit entities for fiscal years beginning after December 15, 2021. This means virtually all private businesses are now required to be in compliance.
• Nonprofit Organizations: Nonprofits that follow GAAP are also subject to ASC 842 and had the same effective date as private companies.
• Small Businesses: Even small businesses that prepare GAAP-compliant financial statements must adhere to ASC 842. If you have a lease for your office, a company car, or a piece of machinery, and its term is longer than 12 months, this standard applies to you.

There is a practical expedient for short-term leases. A company can elect not to apply the recognition requirements of ASC 842 to leases with a term of 12 months or less that do not contain a purchase option the lessee is reasonably certain to exercise. For these leases, a company can continue to recognize lease payments as an expense on a straight-line basis over the lease term, similar to the old rules. However, this election must be made by class of underlying asset and applied consistently.

The Core Change: Operating Leases on the Balance Sheet

To truly grasp the significance of ASC 842, we must focus on the seismic shift of bringing operating leases onto the balance sheet. Under ASC 840, an operating lease was a simple expense. If you paid $5,000 a month for office rent, you recorded a $5,000 rent expense each month. Your balance sheet-the statement that shows your assets, liabilities, and equity-was completely unaffected. Your commitment to pay that rent for the next five years was invisible on the face of your primary financial statements.

ASC 842 completely upends this. Now, that same five-year office lease must be capitalized. This means your company must perform a calculation to determine the present value of all future lease payments. This calculated value is then added to your balance sheet as both an asset (the "Right-of-Use" asset) and a liability (the "Lease Liability").

Why is this so important? Because it dramatically changes a company's financial picture. Suddenly, a company's balance sheet reflects a significant increase in both assets and liabilities. This can make a company appear much larger but also much more indebted. This has far-reaching implications, affecting everything from key financial metrics to the ability to secure a loan. The total amount of liabilities on a company's balance sheet could double or even triple overnight upon adoption of the new standard, without any change in the company's actual operations or cash flow. This "grossing-up" of the balance sheet is the central effect of ASC 842 lease accounting.

Understanding Right-of-Use (ROU) Assets and Lease Liabilities

The two new accounts that are central to ASC 842 are the Right-of-Use (ROU) asset and the Lease Liability. Understanding how they are calculated and how they interact is key to compliance.

Lease Liability

The Lease Liability is the starting point. It represents the lessee's financial obligation to make payments under the lease. It is calculated as the present value of the future lease payments over the lease term. To calculate the present value, you need three key inputs:

1. Lease Payments: This includes fixed payments, variable payments that depend on an index or rate, and amounts probable of being owed under residual value guarantees. It also includes payments for purchase options or termination penalties if the lessee is reasonably certain to exercise them.
2. Lease Term: This is the non-cancelable period of the lease, plus any periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option, and periods covered by an option to terminate if the lessee is reasonably certain not to exercise that option.
3. Discount Rate: This is the interest rate used to discount the future payments back to their present value. The standard states you should use the rate implicit in the lease, if readily determinable. However, for most lessees, this is difficult to calculate. As a practical alternative, private companies are permitted to use their incremental borrowing rate-the rate of interest they would have to pay to borrow on a collateralized basis over a similar term for an amount equal to the lease payments in a similar economic environment.

For example, if a company signs a 3-year lease for a piece of equipment with annual payments of $10,000 and uses a discount rate of 5%, the lease liability would be the present value of those three payments, which is approximately $27,232.

Right-of-Use (ROU) Asset

Once the Lease Liability is calculated, the ROU Asset can be determined. The ROU asset represents the lessee's right to use the underlying asset for the lease term. Its initial measurement is based on the lease liability, but it's adjusted for a few items:

ROU Asset = Initial Lease Liability + Initial Direct Costs + Prepaid Lease Payments - Lease Incentives Received

• Initial Direct Costs: These are incremental costs of a lease that would not have been incurred if the lease had not been obtained, such as commissions paid to a real estate agent.
• Prepaid Lease Payments: Any lease payments made to the lessor at or before the lease commencement date, such as a security deposit or first month's rent.
• Lease Incentives Received: Any payments received from the lessor, such as a tenant improvement allowance.

Over the life of the lease, the Lease Liability is reduced as payments are made (similar to paying down a loan), while the ROU Asset is amortized or depreciated over the lease term.

Operating Leases vs. Finance Leases Under the New Standard

While both lease types now appear on the balance sheet, their classification still matters because it determines how they are treated on the income statement and statement of cash flows. Under ASC 842, a lease is classified as a finance lease if it meets any one of the following five criteria at lease commencement:

1. Ownership Transfer: The lease transfers ownership of the asset to the lessee by the end of the lease term.
2. Purchase Option: The lease contains a purchase option that the lessee is reasonably certain to exercise.
3. Lease Term: The lease term is for a major part of the remaining economic life of the underlying asset. A common rule of thumb used is 75% or more.
4. Present Value: The present value of the sum of the lease payments equals or exceeds substantially all of the fair value of the underlying asset. A common rule of thumb is 90% or more.
5. Specialized Nature: The 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 a lease meets none of these criteria, it is classified as an operating lease. This distinction is crucial for financial reporting.

How ASC 842 Impacts Your Financial Ratios

Capitalizing operating leases has a significant, and often negative, impact on many of the key financial ratios that lenders, investors, and management use to evaluate a company's performance and financial health. Since both assets and liabilities increase, any ratio that uses these figures in its calculation will change.

• Leverage Ratios: The most obvious impact is on leverage ratios. The Debt-to-Equity ratio (Total Liabilities / Shareholders' Equity) will increase because total liabilities are now higher. Similarly, the Debt-to-Assets ratio (Total Liabilities / Total Assets) will also increase. This can make a company appear riskier than it did under the old standard.
• Liquidity Ratios: The Current Ratio (Current Assets / Current Liabilities) will likely decrease. This is because the portion of the lease liability due within one year is classified as a current liability, while the entire ROU asset is typically classified as a non-current asset. This increase in current liabilities without a corresponding increase in current assets puts downward pressure on this key liquidity metric.
• Profitability and Performance Ratios: The impact here depends on the lease classification. For operating leases, there is no change to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), because the single lease expense is an operating expense above the EBITDA line. However, for finance leases, the expense is split into interest and amortization. Since both are excluded from EBITDA, finance leases will result in a higher reported EBITDA. This can be misleading if not properly understood. Ratios like Return on Assets (ROA) will likely decrease because the asset base is now larger.

It's crucial for business owners to understand these changes and be prepared to explain them to their lenders. A sudden spike in your debt-to-equity ratio is alarming on its face, but when it's clearly attributable to an accounting standard change, it can be understood in the proper context.

The Effect on Loan Covenants and Securing Financing

Perhaps the most critical real-world consequence of ASC 842 for many businesses is its impact on debt covenants and the process of applying for new commercial financing. Many loan agreements contain financial covenants that a borrower must maintain, which are often tied to the very ratios that ASC 842 affects.

For example, a common loan covenant might require a company to maintain a Debt-to-Equity ratio below 2.0 or a Current Ratio above 1.5. A company that was comfortably in compliance before adopting ASC 842 could suddenly find itself in violation simply due to the accounting change of capitalizing its operating leases. This could technically trigger a default on the loan, giving the lender the right to demand immediate repayment or renegotiate terms.

When applying for new financing, such as an SBA loan or a business line of credit, lenders will be analyzing your newly formatted balance sheet. A less sophisticated lender might see the increased liabilities and view your business as a higher credit risk, potentially leading to a loan denial or less favorable terms. This is why it's more important than ever to work with a lender, like Crestmont Capital, that understands the nuances of ASC 842 lease accounting.

Businesses should proactively review their existing loan agreements and open a dialogue with their lenders before the changes could cause a covenant breach. Many lenders have been willing to amend loan agreements to adjust covenant calculations for the effects of ASC 842, but this requires proactive communication from the borrower.

Your 9-Step ASC 842 Compliance Checklist

Transitioning to ASC 842 is a significant project that requires careful planning and execution. It is not something that can be left to the last minute. Here is a step-by-step checklist to guide your business through the compliance process:

1. Form a Cross-Functional Team: Compliance is not just an accounting task. Involve representatives from accounting, legal, IT, procurement, and operations. Their collective expertise is needed to identify all leases and gather the necessary data.
2. Educate Stakeholders: Ensure your management team, board of directors, and lenders understand the upcoming changes to the financial statements. Explain why ratios will change and what the impact will be.
3. Develop a Comprehensive Lease Inventory: This is often the most time-consuming step. You must identify and gather every single lease agreement across the entire organization. This includes obvious leases like real estate and vehicles, but also requires a search for "embedded leases."
4. Identify Embedded Leases: Scrutinize service contracts, supply agreements, and other arrangements. A contract might contain an embedded lease if it involves the use of a specific, identified asset that your company controls. Common examples include data center hosting agreements or complex logistics contracts.
5. Extract Key Data Points: For each identified lease, abstract all the critical data needed for calculation, including commencement and end dates, payment amounts and schedules, renewal and termination options, and any variable payment terms.
6. Select an Appropriate Discount Rate: Determine the proper discount rate to use for each lease. For private companies, this will likely be the incremental borrowing rate. Document how this rate was determined.
7. Choose an Accounting Solution: For companies with more than a handful of leases, managing the calculations and ongoing compliance in spreadsheets is risky and inefficient. Evaluate and select a specialized lease accounting software solution to automate the process.
8. Calculate and Record Journal Entries: Perform the calculations to determine the ROU asset and lease liability for each lease. Record the initial transition journal entries and establish a process for recording monthly entries going forward.
9. Prepare New Financial Statement Disclosures: Draft the new quantitative and qualitative footnote disclosures required by ASC 842. These are extensive and require significant detail about your company's leasing activities.

How Lenders View Your Business Post-Implementation

While the new balance sheet presentation might initially look concerning, sophisticated lenders and financial analysts are well-aware of the ASC 842 changes. A knowledgeable lender like Crestmont Capital will not simply deny a loan based on a higher debt-to-equity ratio caused by the new standard. Instead, we adjust our analysis.

Here’s what savvy lenders look at now:

• Adjusted Ratios: We understand that the "new debt" on your balance sheet is not traditional, interest-bearing debt. It's an operating commitment that has always existed, but is now just presented differently. We often calculate adjusted leverage ratios that may exclude operating lease liabilities to get a clearer picture of your traditional debt burden.
• Cash Flow is King: ASC 842 is primarily a presentation change. It does not change the total amount of cash a company pays for its leases. Therefore, lenders will continue to focus heavily on your historical and projected cash flow, which remains the ultimate indicator of your ability to service debt.
• EBITDA Adjustments: We are aware of the potential for EBITDA to be inflated by the reclassification of lease expenses for finance leases. We may look at metrics like EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization, and Rent/Restructuring Costs) to create a more consistent comparison between companies and over time.
• Understanding of Your Business: A good lender looks beyond the numbers. We want to understand your business model, your leasing strategy, and why you lease certain assets instead of buying them. A conversation about your leasing decisions can provide valuable context that raw financial statements cannot.

The key is to partner with a lender who has done their homework on ASC 842. An uninformed lender might see risk where there is only an accounting change. An expert lending partner will see the full picture and focus on what truly matters: your company's operational health and ability to generate cash.

Real-World Scenarios: ASC 842 in Action

Let's look at how ASC 842 might affect different types of businesses:

Scenario 1: The Retail Chain

A retail chain with 25 store locations has 25 separate 10-year leases. Under ASC 840, their balance sheet showed no liability for these long-term commitments. Upon adopting ASC 842, they must calculate the present value of all future rent payments for all 25 stores. This results in millions of dollars in new ROU assets and lease liabilities appearing on their balance sheet. Their debt-to-equity ratio increases substantially, potentially violating a covenant on their line of credit. The CFO must proactively meet with their bank to explain the change and request an amendment to their loan agreement to exclude operating lease liabilities from the covenant calculation.

Scenario 2: The Trucking Company

A mid-sized trucking company leases its fleet of 50 tractor-trailers through various 5-year operating lease agreements. This is a common strategy to keep the fleet modern without large capital outlays. ASC 842 requires them to capitalize all of these leases. When they apply for new equipment financing to purchase new trailers, the lender notes the significant increase in liabilities. However, because the lender is Crestmont Capital, our underwriting team recognizes that this is a non-cash liability from an accounting change. We focus on the company's strong cash flow from operations and approve the financing, helping them continue to grow their business.

Scenario 3: The Restaurant Group

A restaurant group leases its three restaurant spaces and also has a "service contract" with a supplier for all of its kitchen equipment (ovens, refrigerators, etc.). The accounting team correctly identifies the real estate leases but initially overlooks the kitchen equipment contract. Upon closer inspection, they realize the contract specifies particular, identified pieces of equipment that only their restaurants can use for the 5-year contract term. This is an "embedded lease." They must now go through the process of valuing and capitalizing this equipment lease in addition to their real estate leases. This highlights the importance of looking beyond documents titled "Lease Agreement."

Common Pitfalls to Avoid During Transition

The path to ASC 842 compliance is filled with potential missteps. Here are some of the most common mistakes businesses make:

• Underestimating the Effort: Many companies, especially smaller ones, think the transition will be quick and easy. They fail to appreciate the time it takes to locate all lease documents, abstract the data, and perform the calculations. Start early.
• Missing Embedded Leases: As seen in the restaurant example, failing to identify leases hidden within service or supply contracts is a major compliance risk. This requires a thorough review of all vendor contracts.
• Using Spreadsheets for Everything: While tempting for small lease portfolios, managing ASC 842 in Excel is prone to errors, difficult to audit, and creates problems when leases are modified or reassessed. It lacks the controls and automation of dedicated software.
• Incorrect Discount Rate Selection: Using an incorrect or poorly documented discount rate can lead to material misstatements of your lease liabilities and ROU assets. It's a key area of focus for auditors.
• Ignoring Day-2 Accounting: The work isn't done after the initial transition. Leases get modified, renewed, or terminated. Each of these events requires a specific accounting treatment under ASC 842. You need a process to manage these ongoing changes.
• Poor Communication: Failing to communicate the impact of the changes to lenders, investors, and internal management can lead to confusion and misinterpretation of your company's financial health.

Tools and Software for Seamless Compliance

Given the complexity of ASC 842, especially the calculations and ongoing management, many businesses turn to specialized lease accounting software. These platforms are designed to streamline the entire compliance lifecycle.

Key features of lease accounting software include:

• Centralized Lease Repository: A single, secure place to store all lease documents and related data.
• Automated Calculations: The software automatically calculates the lease liability and ROU asset, generates amortization schedules, and creates journal entries.
• Discount Rate Management: Tools to help you manage and apply the correct discount rates.
• End-of-Term Notifications: Alerts for critical dates, such as renewal notice periods or lease expirations.
• Reporting and Disclosure: Automated generation of the footnote disclosures required by ASC 842, saving countless hours for your accounting team.
• Audit Trail: A complete record of all changes and calculations, which simplifies the audit process.

While an investment is required, the time saved, reduction in errors, and improved internal controls provided by a dedicated software solution often deliver a strong return, especially for companies with more than 10-15 leases.

Navigating Financing with Crestmont Capital

At Crestmont Capital, we pride ourselves on being more than just a lender; we are a financial partner who understands the evolving business landscape. The implementation of ASC 842 is a prime example of where our expertise can make a difference for your business.

We know that your balance sheet looks different now. We know your ratios have changed. Our underwriting process is designed to look through these accounting changes to see the true operational strength of your company. When you apply for working capital loans or any other financing product with us, you can be confident that our team:

• Understands ASC 842: We won't be surprised by your larger balance sheet. We will ask the right questions to understand the impact of capitalizing your operating leases.
• Focuses on Cash Flow: We analyze your bank statements and operating history to confirm your ability to support new financing, which is a more reliable indicator than potentially skewed balance sheet ratios.
• Offers Flexible Solutions: We know that navigating these changes can be challenging. We work with you to find the right funding solution that fits your needs, whether it's for expansion, inventory, or managing day-to-day operations. As a leading provider of small business financing, we are committed to finding pathways to say "yes."

Don't let accounting compliance become a barrier to growth. Partner with a lender who is already ahead of the curve.

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Disclaimer: The information provided in this article is for general educational purposes only and is not financial, legal, or tax advice. Funding terms, qualifications, and product availability may vary and are subject to change without notice. Crestmont Capital does not guarantee approval, rates, or specific outcomes. For personalized information about your business funding options, contact our team directly.