IFRS 16 vs ASC 842: What Startup Founders Need to Know About Leases

Lease Accounting: IFRS 16 vs ASC 842 for Startups

That new office lease or bank of servers you just signed for used to be a straightforward monthly expense in QuickBooks or Xero. Now, new accounting rules mean these agreements have a much bigger impact on your startup’s financial statements. For founders navigating fundraising, managing cash flow, and reporting to investors, understanding the lease accounting differences between IFRS 16 and ASC 842 is no longer optional. It directly affects key metrics like EBITDA and can influence everything from loan covenants to your company’s valuation. This is not just a task for a non-existent CFO; it’s a foundational piece of financial hygiene that builds investor trust and prepares you for growth.

Why Leases Are Now on Your Balance Sheet

The fundamental change in lease accounting is a shift from treating most leases as simple operating expenses to recognizing them as assets and liabilities. The goal of the new standards was to increase transparency, giving investors a clearer picture of a company's financial obligations. Before, a monthly lease payment was just another line item on your profit and loss statement, making it difficult to compare companies that leased assets versus those that purchased them.

Today, both IFRS 16 and ASC 842 require that most leases appear on the balance sheet. This process creates two new accounts you need to manage. The first is the Right-of-Use (RoU) asset, which represents your right to use the leased item, like your office space or essential equipment, for the duration of the contract. The second is a corresponding Lease Liability, which represents your financial obligation to make all future lease payments. Think of it this way: you have acquired an asset (the right to use something) and a debt (the promise to pay for it).

However, there is a practical exemption for short-term leases. Leases with a term of 12 months or less are often exempt from this balance sheet recognition, which is a helpful simplification for very short-term arrangements. Both standards also include exemptions for low-value assets, though the specific guidance differs slightly.

Which Lease Accounting Rules Apply to You: IFRS 16 vs. ASC 842

Determining which standard to follow is the first critical step, and it is dictated by geography. For US companies reporting under US Generally Accepted Accounting Principles (GAAP), the standard is ASC 842. For companies in the UK, Europe, and other international jurisdictions that have adopted International Financial Reporting Standards, the standard is IFRS 16.

This distinction becomes a primary pain point for startups with a global footprint. Consider a US-based SaaS company with a UK sales office. The US parent company will consolidate its financials under ASC 842. Meanwhile, the UK subsidiary will prepare its local statutory accounts under IFRS 16. This requires your finance team to reconcile the rule differences during consolidation, adding complexity and risk without a clear understanding of what separates the two standards.

At a high level, both standards agree on the biggest point: most leases belong on the balance sheet. The major divergence, and the one that causes the most confusion for founders, lies in how the expense is treated on the Profit & Loss (P&L) statement. ASC 842 distinguishes between 'finance' and 'operating' leases, which receive different P&L treatments. In contrast, IFRS 16 treats nearly all leases as 'finance leases' for accounting purposes, resulting in both depreciation and interest expense on the P&L.

The Key Difference: How Your Startup's P&L and EBITDA Are Impacted

The most significant of the lease accounting differences between IFRS 16 and ASC 842 is how they impact your P&L and, consequently, your EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). This is not just an accounting nuance; it changes how investors and lenders will interpret your company’s profitability, especially since EBITDA is a common basis for valuation multiples and debt covenants.

ASC 842: The Dual-Model Approach

Under ASC 842 for US companies, leases are classified as either 'operating' or 'finance'. A lease is generally classified as a finance lease if it meets one of several criteria, such as transferring ownership at the end of the term or covering a major part of the asset's economic life. Most typical startup leases for an office or basic equipment do not meet these criteria and fall under the 'operating' lease category. For these, a single, straight-line lease expense is recorded on the P&L. This expense is typically classified as an operating expense, which directly reduces your EBITDA.

IFRS 16: The Single-Model Approach

Under IFRS 16, used internationally, there is no such distinction for the P&L. All leases are treated like 'finance leases'. This means two separate expense lines are recorded: depreciation of the RoU asset and interest on the lease liability. Since both depreciation and interest are added back when calculating EBITDA, the entire lease cost effectively sits below the EBITDA line. The practical consequence tends to be that a company reporting under IFRS 16 will show a higher EBITDA than an identical company reporting under ASC 842, even with the exact same lease.

An Example of the EBITDA Difference

Consider a simple three-year office lease with monthly payments of $10,000, totaling $120,000 per year. Under ASC 842, this operating lease would result in a $120,000 lease expense, reducing EBITDA by the full amount. Under IFRS 16, the P&L would show no single lease expense. Instead, it would record separate depreciation and interest expenses. For example, in the first year, this might be an illustrative $115,000 in depreciation and $15,000 in interest. Since both are added back to calculate EBITDA, the impact on EBITDA is zero. This difference is critical when fundraising or reporting to a board that closely monitors EBITDA as a key performance indicator.

A Practical Playbook for Startups: Data and Calculation

For an early-stage startup, implementing these standards does not require expensive lease accounting software. You can manage the process in a spreadsheet by following a clear, step-by-step approach. This addresses the common pain point of collecting and organizing lease data without a dedicated finance team.

Step 1: Inventory All Your Leases

Go through your contracts and list every agreement longer than 12 months. This includes your office space, any co-working agreements that provide dedicated space, vehicles, and significant office equipment leasing like copiers or servers. Be aware of "embedded leases" where a lease might be part of a larger service contract. For each agreement, gather the key terms: start and end dates, payment amounts and frequency, and any clauses about renewal options, variable payments, or termination penalties.

Step 2: Determine Your Discount Rate

To calculate the lease liability, you need a discount rate to find the present value of your future payments. The guidance for private companies is to use their 'incremental borrowing rate'. In simple terms, this is the interest rate you would pay to borrow funds over a similar term for a similar amount, secured by a similar asset. The best way to find this is to ask your bank for a term sheet on a secured loan matching the lease term and value. It is crucial to document this rate, as you will need it for your calculations and for any future audits. The ASU 2021-09 update provides nonpublic lessees with additional practical expedients for determining this rate.

Step 3: Calculate the Lease Liability

The lease liability is the present value of all future lease payments. You can calculate this in Google Sheets or Excel using the present value formula. The formula is typically =PV(rate, nper, pmt), where 'rate' is your periodic discount rate, 'nper' is the total number of payment periods, and 'pmt' is the payment per period. For a 3-year (36 months) lease at $2,000 per month with an annual incremental borrowing rate of 6% (or 0.5% per month), the formula would be =PV(0.005, 36, -2000). This would give you a lease liability of $65,887 to record on your balance sheet.

Step 4: Record the Right-of-Use Asset

Initially, the Right-of-Use (RoU) asset is calculated as the lease liability amount, adjusted for a few specific items. You add any initial direct costs paid to execute the lease (like commissions or legal fees) and subtract any lease incentives received from the landlord (like a tenant improvement allowance or rent-free periods). For most simple startup leases, the RoU asset will equal the initial lease liability.

Actionable Steps Based on Your Startup's Stage

Understanding the theory is one thing; applying it to your startup's reality is another. Here are practical steps based on your company’s stage.

For Pre-Seed to Seed Stage Startups (1-5 Leases)

The reality for most startups at this stage is more pragmatic: getting the data organized is 90% of the battle. You do not need to over-invest in complex systems yet. Start with a simple spreadsheet in Google Sheets to inventory your leases. For any contract extending beyond 12 months, document the key terms: payments, term length, and renewal options. The most important step is to discuss with your accountant which standard, ASC 842 or IFRS 16, applies to each of your legal entities. This clarity is crucial before performing any calculations. Your QuickBooks or Xero setup can handle the journal entries once the calculations are done in your spreadsheet.

For Series A to Series B Startups (Scaling Operations)

As you scale, especially with multiple offices or international entities, spreadsheets become a significant operational risk. The potential for a formula error to cause misstated EBITDA, covenant breaches, and investor distrust is too high. If you have entities in both the US and UK, the P&L differences between the standards are no longer a minor detail; they materially affect your consolidated financial reports. It is time to evaluate lease accounting software to automate calculations and ensure compliance. Your auditors will thank you. Formalize your process for determining and documenting your incremental borrowing rate annually, and review ASC 842 lease disclosures checklists from AICPA & CIMA. This is not just a compliance exercise; it’s about building a robust financial foundation that supports your growth and builds credibility with investors, lenders, and potential acquirers. For related guidance, see our hub on capex and depreciation.

Frequently Asked Questions

Q: How do ASC 842 and IFRS 16 handle leases for co-working spaces?A: It depends on the contract. If you have an exclusive, identifiable space for a set term, it is likely a lease under both standards. If you have a flexible "hot desk" membership that does not provide control over a specific space, it is typically treated as a service expense.

Q: What is an "embedded lease" and why is it a risk for startups?A: An embedded lease is a lease that exists within a larger service contract, like a data center agreement that includes the exclusive use of specific servers. They are a risk because they are easy to overlook, potentially leading to an understatement of assets and liabilities on your balance sheet.

Q: Are there any other major lease accounting differences between IFRS 16 and ASC 842?A: Yes, another key difference is in the definition of a lease and the treatment of lease modifications. IFRS 16 has a slightly broader definition of a lease. Both standards have detailed guidance on how to account for changes to lease terms, which can be complex to apply correctly.