Navigating Lease Accounting Under ASC 842: Lessons from Implementation

Lease accounting has undergone a significant transformation with the implementation of ASC 842, requiring businesses to recognize most leases on their balance sheets. This change replaced ASC 840 and was intended to enhance financial transparency. However, it has introduced complexities for middle market companies.

For many businesses, transitioning to ASC 842 has been more than just an accounting exercise — it has required cross-functional collaboration, system upgrades and a detailed review of lease agreements. In this article, we’ll explore the core changes under ASC 842, common challenges companies have faced and practical solutions to ensure compliance.

The Core of ASC 842

What’s changed under ASC 842?

The most significant shift under ASC 842 is the requirement for companies to recognize nearly all leases on the balance sheet. Previously, under ASC 840, operating leases were disclosed in footnotes, but now they must be recorded as right-of-use (ROU) assets and lease liabilities.

Key changes include:

• Definition of a lease: A contract is considered a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
• Balance sheet impact: Both operating and finance leases must now be recognized as ROU assets and corresponding lease liabilities.
• Lease classification: While finance leases (formerly capital leases) retain their previous treatment, operating leases are now included on the balance sheet, impacting financial ratios and debt covenants.

These changes require companies to evaluate their lease agreements more carefully and ensure proper classification and measurement.

Common Challenges in Implementing ASC 842

Identifying leases: One of the biggest hurdles has been identifying all lease agreements within an organization. Many companies overlook embedded leases. These are agreements where a lease is hidden within a broader service contract, such as IT contracts that include leased hardware.

Classifying leases: Properly classifying leases as operating or finance can be tricky. Misclassifications can lead to incorrect financial reporting that may trigger audit findings or covenant violations.

Selecting a discount rate: ASC 842 requires companies to apply a discount rate to calculate the lease liability. While public companies must use the rate implicit in the lease or their incremental borrowing rate (IBR), private companies have the option to use a risk-free rate. Selecting the appropriate discount rate has proven difficult, especially for middle market firms without a defined borrowing rate.

Gathering data and systems challenges: For businesses with a large number of leases, gathering the necessary data has been an overwhelming task. Many companies store lease information across multiple departments, including legal, procurement, operations and finance, making it challenging to centralize data for proper accounting.

Practical Solutions and Best Practices

Leveraging technology: Using lease accounting software can help businesses automate calculations, store lease data and generate journal entries. Many companies that initially relied on spreadsheets are now transitioning to dedicated lease management tools to improve accuracy.

Conducting a lease portfolio review: A structured lease review helps businesses ensure they’ve captured all relevant agreements under ASC 842. Companies should:

• Identify embedded leases in service contracts.
• Review lease terms to determine classification.
• Ensure completeness by reconciling lease commitments to existing contracts.

Choosing an appropriate discount rate: Private companies can simplify lease calculations by electing the risk-free rate as allowed under ASC 842. However, businesses with significant lease liabilities may benefit from using their IBR to better reflect their financial standing.

Cross-department collaboration: Since leases impact multiple areas of a business, finance teams should work closely with legal, procurement and operations teams to ensure that all lease contracts are properly recorded. Regular training can also help nonaccounting teams recognize and report lease agreements.

Lessons from Implementation

Companies that have successfully implemented ASC 842 have learned valuable lessons, including:

• Start early: Businesses that waited until the last minute faced data issues and compliance risks.
• Document assumptions: Many organizations had to make judgment calls on discount rates, lease terms and options to renew — documenting these decisions helps ensure consistency.
• Audit preparedness: Companies that maintained detailed lease documentation and aligned their policies with auditors had a smoother transition.

Moving Forward: Maintaining Compliance

Now that ASC 842 is in effect, businesses must focus on ongoing lease management. Steps include:

• Monitoring lease modifications: Changes in lease terms, renewals or impairments require continuous updates to lease calculations.
• Ensuring proper disclosure: Businesses should review footnote disclosures to ensure they meet ASC 842 requirements.
• Preparing for audits: Keeping a well-documented lease portfolio and accounting policy memo will streamline the audit process.

Key Takeaways

The transition to ASC 842 has been a major shift for middle market companies, but those who approach it proactively can mitigate risk and improve financial transparency. By leveraging technology, improving lease data management and maintaining compliance, businesses can ensure that lease accounting remains accurate and efficient.

If your company is refining its lease accounting processes and needs help understanding ASC 842, our professionals can help you with reviewing policies, assessing lease portfolios and adopting best practices, keeping you ahead of potential challenges. Contact us today.

Authored by Hasan Abbas

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