Small Business Lease Accounting: What ASC 842 Asks and Where It Simplifies

Small business lease accounting under US GAAP follows ASC 842, the same standard large companies use. ASC 842-20-25-1 states the core rule: "At the commencement date, a lessee shall recognize a right-of-use asset and a lease liability." That covers operating leases as well as finance leases. The standard then gives a private company six ways to cut the work, and this page walks through each.

For private companies, ASC 842 took effect for fiscal years beginning after December 15, 2021. ASU 2020-05 set that date, so a calendar-year company first applied it in 2022. The standard has no size exemption. What a small company gets is a set of policy choices, most of them made by class of underlying asset.

Does a small business have to apply ASC 842 at all?

Only when it issues financial statements under US GAAP. ASC 842 is part of the FASB Codification, so it governs statements prepared on that basis. A lender, a bonding company or an outside investor often asks for GAAP statements. When that is the request, the leases come with it.

Many small businesses report another way. The AICPA describes the tax basis, the cash basis and the modified cash basis as special purpose frameworks. It treats them as alternatives to US GAAP. Statements prepared on one of those bases do not apply ASC 842.

This page covers the GAAP case only. Which framework a business uses is settled between its owners, the users of its statements and its CPA.

What does ASC 842 put on a small company's books?

Two balances for each lease. ASC 842-20-30-1 measures the lease liability at the present value of the lease payments not yet paid, discounted at the rate for the lease at commencement. ASC 842-20-30-5 then builds the right-of-use (ROU) asset from that liability. It adds payments made at or before commencement, subtracts lease incentives received, and adds initial direct costs.

So a company with an office lease, four vans and a copier needs a schedule for each one. Each schedule needs a lease term, a payment stream and a discount rate. The ASC 842 lease accounting guide covers classification and the entries after day one.

For a small team the math is rarely the hard part. The hard part is finding every lease, including the ones inside service contracts, and keeping the list current. The page on lease population completeness shows how that list is built and tested.

Which ASC 842 simplifications can a private company elect?

Six, and they are not alike. Four are written into the Codification as elections. One rests on the FASB's basis for conclusions, and one is a materiality policy that accounting firms describe. The matrix sets them side by side, with the paragraph behind each and what it does on the books.

Three of the six are made by class of underlying asset, so a company can elect one for vans and not for real estate. Each is an ongoing accounting policy, not a one-time transition choice. The wider set, with the transition package, is on the ASC 842 practical expedients page.

Which leases can stay off the balance sheet as short-term leases?

The Master Glossary defines a short-term lease by two tests at the commencement date. The lease term is 12 months or less. And there is no purchase option that the lessee is reasonably certain to exercise. ASC 842-20-25-2 then lets a lessee elect, as an accounting policy, not to apply the recognition requirements to those leases.

On the books, the lease payments go to profit or loss on a straight-line basis over the lease term. Variable lease payments are expensed in the period the obligation is incurred. No asset or liability appears. The same paragraph says the election is made by class of underlying asset.

The 12 months are counted on the lease term, not on the stated term alone. The Codification's own example, at ASC 842-20-55-15, is a 12-month vehicle lease with a 12-month option to extend. It qualifies because the lessee is not reasonably certain to extend. Had the lessee been reasonably certain, the lease term would run past 12 months.

The answer can also change later. ASC 842-20-25-3 names two triggers. The remaining lease term is reassessed to run more than 12 months past the end of the term previously determined, or the lessee becomes reasonably certain to exercise a purchase option. Either way the lease no longer meets the definition of a short-term lease.

The detail is on the short-term leases page.

How much does the risk-free rate election change the lease liability?

ASC 842-20-30-3 sets the order. A lessee uses the rate implicit in the lease whenever that rate is readily determinable. If it is not, the lessee uses its incremental borrowing rate (IBR).

The same paragraph holds the election. A lessee that is not a public business entity is permitted to use a risk-free discount rate in place of its IBR. The risk-free rate is set using a period comparable with the lease term. Since ASU 2021-09, the choice is made by class of underlying asset, not for the whole entity at once.

The election removes an estimate. An IBR has to be built and supported, and a small company with one bank line often has little to build it from. A risk-free rate can be read from a published source. The election does not displace the rate implicit in the lease when that rate is readily determinable.

One lease measured at both rates

Birchfield Mechanical is a made-up private contractor. It signs a five-year lease of shop equipment at $60,000 a year, paid at the end of each year. There are no prepaid amounts, incentives or initial direct costs.

Assume a risk-free rate of 4% for a five-year period and an IBR of 7%. Both rates are made up for the example. They are not market quotes.

At 4% the liability is $60,000 × 4.451822 = $267,109. At 7% it is $60,000 × 4.100197 = $246,012. The risk-free figure is $21,097 larger, about 8.6%. A lower rate discounts each payment less, so more of the $300,000 sits on the balance sheet on day one.

The ROU asset is larger by the same amount, because it starts from the liability. Cash does not change. Birchfield pays $300,000 under either rate. What moves is total liabilities, and with it any ratio a lender works out from the balance sheet.

That is the trade: less estimation work against a larger reported liability. Readers can see the choice too. A lessee that elects the risk-free rate discloses the election and the asset classes it covers. Deloitte's Roadmap, section 15.2, files that requirement under ASC 842-20-50-3(c)(3).

The borrowing rate under ASC 842 page covers how an IBR is built.

What happens when lease and non-lease components are not separated?

The default is to split them. ASC 842-10-15-30 requires the consideration in the contract to be allocated to each separate lease component and non-lease component. Common area maintenance is a typical non-lease component. The example at ASC 842-10-55-144 treats it as a separate non-lease component, because the lessor's upkeep of shared areas is a service to the lessee.

ASC 842-10-15-37 offers the way around the split. A lessee may elect, by class of underlying asset, not to separate non-lease components from lease components. It then accounts for each lease component and its related non-lease components as a single lease component. For an office lease with fixed upkeep charges, the whole fixed payment goes into the lease liability.

That saves the allocation work and makes the liability larger. Deloitte's Roadmap, section 4.3.3.1, adds a second effect. All fixed payments count in the classification tests, which "may result in the classification of more leases as finance leases."

The election also matters for a service contract that has a lease inside it. The embedded leases under ASC 842 page covers how those are found.

Can similar leases be accounted for as a portfolio?

Yes, within a limit. Deloitte's Roadmap, section 8.2.2, reads ASC 842 as permitting portfolio-level accounting on one condition. The leases commenced at or around the same time, and the result would not differ materially from lease-by-lease accounting. The Roadmap expects similar assets and nearly identical contract terms.

A fleet of vans under one master agreement is the usual small-company case. On the books, one discount rate and one lease term assumption serve the group.

The FASB's basis for conclusions says how far the judgment may go. Paragraph BC120 of ASU 2016-02, as reproduced in the Roadmap, says the Board "did not intend for an entity to quantitatively evaluate each outcome." A reasonable approach to forming the groups is enough. Paragraph BC121 adds that the relief can be greatest where judgment is needed, such as the discount rate or the lease term.

How does ASC 842 treat a lease with a related company under common control?

Many small businesses rent their building from an entity with the same owners, often on thin paperwork. ASU 2023-01 added ASC 842-10-15-3A for that case. A private company may use the written terms and conditions of a common control arrangement to determine whether it is or contains a lease. If it is, the company classifies and accounts for that lease on the same written terms.

The choice is made one arrangement at a time. It is not open when no written terms or conditions exist (ASC 842-10-15-3B). The ASU took effect for fiscal years beginning after December 15, 2023.

Is there a dollar threshold below which a lease can be ignored?

Not in the Codification. ASC 842 sets no dollar amount below which a lease stays off the books. Deloitte's Roadmap, section 2.2.5.2, notes that the standard has no small-ticket exception like the one in IFRS 16. What follows is the firm's reading, not Codification text.

The Roadmap points to paragraph BC122 of ASU 2016-02. As reproduced there, the Board said entities "will likely be able to adopt reasonable capitalization thresholds below which lease assets and lease liabilities are not recognized." The Roadmap develops the idea by comparing it to the way companies already set a floor for capitalizing property, plant and equipment.

The Roadmap adds two cautions. A fixed-asset floor ignores the liability side, so it cannot be borrowed as is. And the test is run on the gross asset and the gross liability. The net effect of a lease entry is often zero, and that proves nothing.

One approach the Roadmap describes is to use the lesser of an asset threshold and a liability threshold. On the books, a lease under the threshold is expensed as paid, like a short-term lease. The written policy and the materiality work behind it are what an auditor asks to see.

Frequently asked questions

Does a small business have to follow ASC 842?

Only when it issues financial statements under US GAAP. A lender, a bonding company or an investor may ask for them. ASC 842 has no size exemption, and for private companies it took effect for fiscal years beginning after December 15, 2021. Statements on the tax basis or the cash basis follow a special purpose framework, not ASC 842.

Can a private company use the risk-free rate for its leases?

Yes. ASC 842-20-30-3 lets a lessee that is not a public business entity use a risk-free discount rate in place of its incremental borrowing rate. The election is made by class of underlying asset. A risk-free rate is normally lower, so the lease liability and the right-of-use asset come out larger.

Is there a minimum dollar amount for recording a lease under ASC 842?

No. ASC 842 sets no dollar threshold. Deloitte's Roadmap reads paragraph BC122 of ASU 2016-02 as allowing a reasonable capitalization threshold based on materiality. The test looks at the gross asset and the gross liability, not the net effect.

Sources and further reading

• Deloitte's Roadmap, 8.4 Recognition and Measurement. It reproduces ASC 842-20-25-1, 842-20-30-1 and 842-20-30-5.
• Deloitte's Roadmap, 8.2 Policy Decisions That Affect Lessee Accounting. It reproduces ASC 842-20-25-2, 842-20-25-3 and 842-20-55-15, and the short-term lease definition. It also covers the portfolio approach, with BC120 and BC121.
• Deloitte's Roadmap, 7.2 Determination of the Discount Rate for Lessees. It reproduces ASC 842-20-30-3.
• ASU 2021-09, Discount Rate for Lessees That Are Not Public Business Entities, on PwC Viewpoint. This is the by-class change to the risk-free rate election.
• Deloitte's Roadmap, 4.3 Identify the Separate Nonlease Components. It reproduces ASC 842-10-15-30, 842-10-15-37 and 842-10-55-144. The finance lease remark quoted above is in section 4.3.3.1.
• Deloitte's Roadmap, 2.2 Scope Exclusions, section 2.2.5.2. It covers lease thresholds and quotes BC122 of ASU 2016-02.
• Deloitte's Roadmap, 15.2 Lessee Disclosure Requirements, on disclosing the risk-free rate election.
• ASU 2023-01, Common Control Arrangements, on PwC Viewpoint. It holds ASC 842-10-15-3A and the effective date in ASC 842-10-65-7.
• Deloitte, Heads Up: FASB Issues Guidance on Common-Control Lease Arrangements.
• ASU 2020-05, Effective Dates for Certain Entities, on PwC Viewpoint. It sets the private-company date.
• AICPA Center for Plain English Accounting, Tax- and Cash-Basis Financial Statements, on special purpose frameworks.
• AICPA, Frequent questions about special purpose frameworks.

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