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Lease accounting has undergone a significant transformation with the introduction of ASC 842. This new standard, issued by the Financial Accounting Standards Board (FASB), aims to bring greater transparency to lease obligations by requiring lessees to recognize nearly all leases on their balance sheets.
For small and mid-sized businesses, the transition to ASC 842 has not been easy. The standard demands new calculations, updated policies, and deeper coordination between finance, legal, and operations teams. For CPA firms supporting these businesses, implementation presents both a technical challenge and a strategic opportunity.
At Madras Accountancy, we help U.S.-based CPA firms manage ASC 842 compliance efficiently through offshore accounting and audit support. In this guide, we break down what ASC 842 requires, how to classify leases, how to calculate right-of-use (ROU) assets and lease liabilities, and how to implement the new framework without disrupting day-to-day business operations.
ASC 842 is the updated lease accounting standard issued by FASB to replace ASC 840. It became effective for public companies in 2019 and for private companies in fiscal years beginning after December 15, 2021. The core goal of ASC 842 is to increase visibility into lease commitments by requiring lessees to recognize most leases on their balance sheets.
Under ASC 842, lessees must:
Previously, operating leases could remain entirely off-balance sheet. That is no longer allowed under the new guidance.
This change affects not just how businesses report financials, but also how they negotiate lease terms, track data, and prepare for audits.
Before diving into compliance steps, it is important to understand some core terms introduced or redefined by ASC 842:
Lease: A contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
Right-of-Use (ROU) Asset: The lessee’s right to use the underlying asset during the lease term.
Lease Liability: The present value of lease payments the lessee is obligated to make over the lease term.
Lease Term: The non-cancellable period of the lease, plus optional renewal periods the lessee is reasonably certain to exercise.
Embedded Lease: A lease component hidden within a broader service or supply agreement. These must be identified and accounted for under ASC 842.
Incremental Borrowing Rate (IBR): The rate of interest a lessee would have to pay to borrow an amount equal to the lease payments over a similar term and with similar collateral.
ASC 842 applies to all entities that enter into lease agreements, including:
There are no carve-outs for small businesses or startups. If your company leases office space, equipment, vehicles, or any other asset, ASC 842 applies.
CPA firms supporting clients with leased assets must assess all contracts and determine the appropriate accounting treatment under ASC 842.
The implementation of ASC 842 is not just an accounting adjustment. It requires coordination across departments, detailed documentation, and often, software tools to manage lease data. Here is a step-by-step guide to help CPA firms and their clients navigate the transition.
Start by gathering all contracts that may include leases. This includes:
Each contract must be reviewed to determine if it meets the definition of a lease under ASC 842.
Tips for identification:
Once leases are identified, classify them as either finance or operating:
Finance Leases:
These are treated like asset purchases and result in front-loaded expense recognition.
A lease is a finance lease if it meets any of these criteria:
Operating Leases:
If none of the above criteria are met, the lease is operating. It results in straight-line expense recognition over the lease term.
CPA firms should help clients document their classification decisions in a lease summary file.
For both finance and operating leases, lessees must recognize:
Inputs required:
Example:
Let’s say a business signs a 3-year lease for office space with monthly payments of $5,000 and no renewal option. Assuming an incremental borrowing rate of 6 percent:
Most small businesses will use the incremental borrowing rate, since the implicit rate is often unknown.
For finance leases:
For operating leases:
CPA firms can use templates or lease accounting software to generate accurate schedules and journal entries.
ASC 842 requires changes in internal policies related to:
Establishing a documented policy is important for audits and internal consistency. CPA firms should help clients formalize these updates in a lease accounting manual or SOP.
There are two main transition methods:
Modified Retrospective (Comparative):
Apply ASC 842 to all periods presented, requiring restatement of prior year financials.
Modified Retrospective (Cumulative):
Apply ASC 842 from the adoption date only. Prior years are not restated.
Most small businesses use the cumulative method for simplicity. Disclosure of the transition approach is required in the financial statements.
Once leases are identified, classified, and measured, companies must record the appropriate journal entries. Below is a general example of how entries differ between finance and operating leases.
At Lease Commencement (Both Types):
Dr. Right-of-Use Asset
Cr. Lease Liability
For Finance Leases (Ongoing):
Lease liability interest component:
Dr. Interest Expense
Cr. Lease Liability
Amortization of ROU asset:
Dr. Amortization Expense
Cr. Accumulated Amortization
For Operating Leases (Ongoing):
Straight-line lease expense:
Dr. Lease Expense
Cr. Lease Liability
Cr. ROU Asset
Each lease will vary based on terms, so actual journal entries should reflect contract-specific data. CPA firms can automate these through lease management tools or provide clients with templates that are audit-ready.
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Many service contracts include use of dedicated assets. If a company has control over a specific asset during the term and benefits substantially from its use, that component may qualify as a lease.
Examples include:
These contracts must be separated into lease and non-lease components and accounted for accordingly.
ASC 842 allows companies to exempt leases with a term of 12 months or less (including renewal options not reasonably certain to be exercised). These leases do not require ROU asset or liability recognition but must still be disclosed.
CPA firms must advise clients to apply this policy consistently and document election of the exemption in their accounting policy.
Not all lease payments are fixed. ASC 842 distinguishes between:
Variable payments should be clearly tracked and disclosed, even if not capitalized.
ASC 842 requires enhanced financial statement disclosures. The goal is to provide users of financial statements with clear insight into leasing arrangements and obligations.
Key disclosure requirements include:
CPA firms should prepare clients for detailed disclosures, especially if financials are reviewed or audited.
Manual tracking of lease data is possible but increasingly impractical, especially with multiple locations or equipment contracts. Lease accounting software can improve accuracy and efficiency.
Features to look for:
For clients with fewer than 10 leases, Excel templates created by CPA firms may suffice. For those with more complex portfolios, dedicated lease software is recommended.
Many businesses underestimate the effort required for ASC 842 compliance. Here are common mistakes to watch for:
These errors can lead to financial restatements or audit issues. CPA firms can add value by helping clients avoid them through proactive engagement.
ASC 842 implementation places a heavy administrative burden on CPA firms already stretched by tax season, client growth, and audit prep. That is where Madras Accountancy steps in.
We support U.S.-based CPA firms with:
By leveraging our offshore accounting team, firms can deliver ASC 842 support at scale without compromising quality or profitability.
ASC 842 brings lease obligations out of the shadows and onto the balance sheet. While the standard increases complexity, it also provides better visibility into long-term financial commitments.
For small and mid-sized businesses, getting lease accounting right is not just a compliance issue. It impacts loan covenants, investor confidence, and financial health. CPA firms play a critical role in helping clients implement ASC 842 effectively.
With the right tools, clear documentation, and expert support, your clients can navigate lease compliance confidently and accurately.
Question: What is ASC 842 and how does it change lease accounting for small and mid-sized businesses?
Answer: ASC 842 is the new lease accounting standard that requires lessees to recognize most leases on their balance sheets as right-of-use assets and lease liabilities, replacing the previous standard that kept operating leases off-balance-sheet. This change affects small and mid-sized businesses by requiring balance sheet recognition for leases over 12 months, including office space, equipment, vehicles, and other leased assets. The standard aims to provide more transparent reporting of lease obligations to investors and creditors. While it doesn't change cash flows, ASC 842 significantly impacts financial statement presentation, financial ratios, and debt covenant compliance for businesses with significant lease commitments.
Question: Which businesses are required to comply with ASC 842 and when did implementation deadlines occur?
Answer: ASC 842 applies to all entities following US GAAP, including public and private companies, nonprofits, and employee benefit plans. Public companies implemented ASC 842 in 2019, while private companies and small businesses had until fiscal years beginning after December 15, 2021 (generally 2022 for calendar year entities). Small businesses meeting specific criteria may qualify for simplified accounting treatments, but most entities must apply the full standard requirements. The standard applies to virtually all lease arrangements except short-term leases (12 months or less) and leases of intangible assets. Implementation requires retrospective application with various practical expedients available to ease transition burdens.
Question: How should businesses identify and classify leases under ASC 842?
Answer: Identify leases under ASC 842 by determining whether contracts convey the right to control identified assets for specific periods in exchange for consideration. Control exists when lessees have the right to obtain substantially all economic benefits from asset use and direct how and for what purpose assets are used. Classify leases as either finance leases (similar to capital leases under old standards) or operating leases based on five criteria including ownership transfer, purchase options, lease terms relative to asset life, present value tests, and specialized asset nature. Finance leases result in front-loaded expense recognition, while operating leases produce straight-line expense patterns. Proper classification affects income statement presentation and requires careful evaluation of lease terms and conditions.
Question: What are the key calculation requirements for lease accounting under ASC 842?
Answer: Key ASC 842 calculations include determining lease liability as the present value of future lease payments discounted using implicit lease rates (if determinable) or incremental borrowing rates. Right-of-use assets equal lease liabilities plus prepaid rent, initial direct costs, and less lease incentives received. Lease payments include fixed payments, variable payments based on indices or rates, exercise prices of purchase options reasonably certain to be exercised, and termination penalties if lease terms reflect termination expectations. Calculate incremental borrowing rates based on what lessees would pay for similar financing arrangements. Regular remeasurement may be required for changes in lease terms, purchase option assessments, or payment amounts.
Question: What practical expedients are available to simplify ASC 842 implementation?
Answer: ASC 842 provides several practical expedients to simplify implementation including the package of three expedients allowing entities to not reassess lease identification, classification, or initial direct costs for existing leases. Additional expedients include using hindsight for lease term and purchase option assessments, not separating lease and non-lease components for certain asset classes, and applying short-term lease recognition exemptions. Entities can elect expedients on an asset class basis and must consistently apply chosen expedients. These expedients significantly reduce implementation effort by allowing entities to carry forward previous judgments while adopting new recognition and measurement requirements. However, expedients must be elected consistently and documented appropriately.
Question: How does ASC 842 impact financial statements and key financial ratios?
Answer: ASC 842 impacts financial statements by adding right-of-use assets and lease liabilities to balance sheets, potentially increasing total assets and liabilities significantly for businesses with substantial lease commitments. Financial ratios affected include debt-to-equity ratios, current ratios, asset turnover ratios, and return on assets calculations. Income statement timing changes for finance leases with front-loaded interest expense recognition, while operating leases maintain straight-line expense patterns. Cash flow statements show lease payments in operating activities for operating leases and split between operating and financing activities for finance leases. These changes may affect debt covenant compliance, lending agreements, and financial performance metrics requiring communication with stakeholders.
Question: What systems and processes should businesses implement for ongoing ASC 842 compliance?
Answer: Implement systems for ongoing ASC 842 compliance including lease tracking databases, automated calculation tools, and regular monitoring procedures for lease modifications and remeasurements. Establish procedures for identifying embedded leases in service contracts, tracking lease terms and options, and calculating incremental borrowing rates. Implement approval processes for new leases, modification assessments, and purchase option evaluations. Use lease accounting software or enhanced spreadsheet tools for complex calculations and reporting requirements. Establish regular review cycles for lease portfolios, document significant judgments and estimates, and maintain audit trails for all lease accounting decisions. Training for accounting staff and lease administrators ensures consistent application of standard requirements.
Question: What common implementation challenges should businesses prepare for with ASC 842?
Answer: Common ASC 842 implementation challenges include identifying all lease arrangements throughout organizations, determining incremental borrowing rates for present value calculations, and establishing systems for ongoing compliance monitoring. Businesses often struggle with embedded lease identification in service contracts, complex modification accounting, and technology system limitations for lease tracking. Additional challenges include coordination between accounting and operational teams, training staff on new requirements, and communicating financial statement impacts to stakeholders. Resource constraints and competing priorities can delay implementation efforts. Address challenges through early planning, cross-functional teams, professional assistance when needed, and phased implementation approaches. Proper preparation and adequate resources significantly improve implementation success and ongoing compliance effectiveness.
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