A lender tests a covenant. The ratio has moved against you. Revenue is up, margins are steady, you have not borrowed anything, and nothing about how you run the business has changed. What changed is where your lease is recorded.
This still catches small businesses out, several years after the rule took effect, because it is one of the few accounting changes that alters the balance sheet without touching the profit and loss. If you only ever look at the P&L — and most owners only ever look at the P&L — there is nothing to see.
What ASC 842 Actually Did
Under the old standard, an operating lease lived in a footnote. You disclosed your future commitments and that was the end of it. The obligation to pay rent for the next six years was real, and it was nowhere on the balance sheet.
ASC 842 put it there. For nearly every lease longer than a year you now recognize two things: a right-of-use asset, representing your right to use the space or the equipment, and a lease liability, representing what you have promised to pay for it. They start out roughly equal and then diverge as the lease runs down.
It has applied to private companies since fiscal years beginning after 15 December 2021, so for a calendar-year business the first affected year was 2022.
The Part That Surprises People
For an operating lease, the income statement barely moves. You still recognize a single straight-line lease cost in operating expenses, much as you recognized rent before. Same profit, same EBITDA.
The balance sheet is a different story. Total assets go up and total liabilities go up, by an amount that depends on how long your lease has left to run. A business with eight years remaining on a warehouse can add a liability larger than every other liability it has.
Anything measured against total liabilities or total assets therefore moves: debt-to-equity, debt-to-assets, tangible net worth. If a loan agreement defines those terms by reference to GAAP, the definition now includes something it did not include when the agreement was signed.
This is worth raising with a lender before they raise it with you. A covenant breach you predicted and explained is a conversation. The same breach discovered in a compliance certificate is a problem.
Operating or Finance Changes the Answer
Not every lease is an operating lease. If the arrangement effectively transfers control of the asset to you — ownership passes at the end, there is a purchase option you are reasonably certain to exercise, the term covers most of the asset's remaining economic life, or the payments amount to substantially all of its fair value — it is a finance lease.
Both types sit on the balance sheet. They hit the income statement differently. A finance lease is split into amortization of the right-of-use asset plus interest on the liability, and both of those fall below the line most people draw for EBITDA. So the classification that leaves your balance sheet looking similar can change your EBITDA — which matters if anything you are measured on, or valued on, is a multiple of it.
Classification is decided at the start of the lease, from the facts of that lease. It is not a preference.
Two Things That Keep a Lease Off the Balance Sheet
A lease with a term of twelve months or less, and no purchase option you are reasonably certain to exercise, can be kept off the balance sheet by policy election. The election is made by class of underlying asset, not lease by lease, and once made it applies to the whole class — so it is a decision to document, not one to make retroactively when a balance sheet looks inconvenient.
The other thing to get right is the discount rate, because it sets the size of the liability. You use the rate implicit in the lease, or your incremental borrowing rate where the implicit rate is not readily determinable — which, for most small-business leases, is the usual answer, since a landlord does not tell you their implicit rate. Private companies may instead elect a risk-free rate by class of asset. That election is simpler to apply and it produces a larger liability, so it is a trade, not a shortcut.
What to Check
- List every lease you are party to — premises, vehicles, copiers, equipment, storage — with its remaining term and its renewal options.
- Confirm which are on the balance sheet today and which are not, and why.
- Read the covenant definitions in every loan and line of credit you have, and check whether they are defined by reference to GAAP.
- Recalculate the ratios those covenants test, with the lease liabilities included.
- If a renewal or a new lease is coming, price the balance-sheet effect before signing, not after.
Where This Comes From
FASB ASC Topic 842, Leases, including the short-term lease policy election and the private-company risk-free rate election. Effective for private companies for fiscal years beginning after 15 December 2021.
This is general information about a US GAAP reporting standard as it stood in August 2026, not advice about your situation. Lease classification and covenant definitions are specific to the documents in front of you. We prepare financial statements; we do not attach an audit, a review, a compilation or any other form of assurance to them.
This post is general information about federal and state tax rules, not advice about your situation. Rules change. Check the date above before you rely on anything here, and talk to us about your own facts.