The new lease accounting standards are significantly changing the accounting for operating leases. In this blog, we will provide a comprehensive example of operating lease accounting under ASC 842. Specifically, how to transition an operating lease from the old lease accounting standard, ASC 840, to the new standard, ASC 842. We will be using a real life scenario that one of our clients graciously allowed us to use as an example.
What is an operating lease?
An operating lease is a contract where an owner of an asset, referred to as the lessor, gives someone, the lessee, access to that asset. Typically, the lessee is able to use the asset for a period of time, which is less than the economic life of the asset, in exchange for the lessee making payments for an agreed upon period of time.
Under both ASC 840 and ASC 842, leases are separated into two classifications. The term operating leases exists in both standards, although the accounting is different in each standard. Under ASC 840, there was a capital lease classification. This changed to the terminology finance lease in ASC 842, but the accounting is consistent for this classification between the two standards.
When it comes to the treatment of operating leases under ASC 840 and ASC 842, there are a few distinct changes.
Operating lease treatment under ASC 842 vs. ASC 840: What is changing?
Under ASC 840, operating leases were considered off-balance sheet transactions. The rent expense associated with the arrangements was recognized in the income statement, but there was not any balance sheet impact. This made it difficult to understand the volume of commitments a company had entered into. It could also make comparisons between companies difficult, depending on if they had different approaches to leased vs. capital assets. In an effort to increase transparency, the FASB issued ASC 842, Leases. One of the provisions of this new standard is that all leases must be recognized on a company’s balance sheet. For operating leases, ASC 842 requires recognition of a right of use (ROU) asset and a corresponding lease liability upon lease commencement.
Operating lease vs. finance lease identification under ASC 842
Lease classification under ASC 842 is relatively similar to the operating lease vs. capital lease criteria under ASC 840, but certain “bright lines” for classification have been removed consistent with the more “principles-based” approach of ASC 842. For a lease to be classified as a finance lease, it must meet one of the five finance lease criteria, listed below. If the lease does not fall under any of these criteria, it is classified as an operating lease:
1. Transference of title/ownership to the lessee
There is a transfer of ownership of the underlying asset to the lessee by the end of the lease term.
2. Purchase option
The lease arrangement grants the lessee an option, which is reasonably certain to be exercised, to purchase the asset.
3. Lease term for major part of the remaining economic life of the asset
The lease term is for a major part of the remaining economic life of the underlying asset.
Note: The FASB provided some additional clarification that “major part” would be consistent with the 75% threshold used under ASC 840.
4. Present value represents “substantially all” of the fair value of the asset
The present value of the sum of the remaining lease payments equals or exceeds substantially all underlying asset’s fair value. If applicable, any residual value guarantee by the lessee that is not already included in lease payments would also be included in the present value calculation.
Note: The FASB provided some additional clarification that “substantially all” would be consistent with the 90% threshold used under ASC 840.
5. Asset specialization
The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
Is lease capitalization required for all operating leases under 842?
No. An entity can make an accounting policy election to treat operating leases with a lease term of 12 months at transition/lease commencement (and which does not have a purchase option that is reasonably certain of exercise) consistent with the recognition approach under ASC 840, which does not require capitalization of a lease asset or liability on the balance sheet.
Further, while ASC 842 does not have an exclusion for low-value assets, some companies have established a capitalization threshold. Similar to a capitalization threshold for fixed assets, the company has determined that leases below this value are not material to the company and therefore, are not recognized.
Operating lease accounting example and journal entries
The following is a full example of how to transition an operating lease from ASC 840 to the new standard, ASC 842.
Details on the example lease agreement:
First, assume a tenant signs a lease document with the following predicates:
Lease term
A term commencing on April 1, 2016 (commencement date) and continuing for one-hundred-twenty (120) full calendar months. The tenant shall be granted access to the premises sixty (60) days prior to the commencement date to install equipment and furnishings (the “early access period”). Such access shall be subject to all the terms and conditions of this lease, except that the commencement date and the payment of rent shall not be triggered thereby.
Tenant improvement allowance
The tenant received a TIA, or tenant improvement allowance, of $1.2 million as an incentive to sign the lease from the landlord. The landlord paid the contractor directly for the construction of the improvements. The improvements were constructed prior to the early access period.
Moving expenses
The tenant also received a reimbursement of $30,000 in moving expenses from the landlord.
Base rent
Per the lease document, the rent commencement date is three full calendar months after the tenant opens for business at that location. Base rent is $205,000/month; with annual increases on the anniversary of the rent commencement date of 3%.
Assumptions
Assume that the lease is classified as an operating lease, that the tenant is a private company, that the rate implicit in the lease is unknown, and the fair value of the building is $300 million. Assume the tenant opened for business at the location on June 1, 2016. Assume that the company’s incremental borrowing rate would be 6% in 2016 and 9% in 2022.
Here are the steps to take to correctly transition the above lease:
Step 1: Determine the lease term under ASC 840
The lease term stated in the contract is 120 months, however the document states that the tenant shall be granted access subject to all the terms and conditions in the lease document during the “early access” period. Assuming the early access period started on February 1, 2016, then for GAAP purposes the lease really started on that date (accounting lease commencement date), and the lease term is actually 122 months; from February 1, 2016 through March 31, 2026.
Note: To understand the difference between the commencement date, execution date, possession dates, etc, read this article on when a lease starts.
Step 2: Determine the total lease payments under GAAP
The rent commencement date is September 1, 2016 (3 months from the date the tenant opened for business). The total lease payments are $26,863,751.
Step 3: Prepare the straight-line amortization schedule under ASC 840
The lease term is 122 months (from step 1), total rent is $26,863,751 (from step 2). Straight-line monthly rent expense calculated from base rent is therefore $220,195 ($26,863,751 divided by 122 months).
See below for a screenshot of the partial straight-line amortization schedule.
Note however, that there is a total incentive of $1,230,000 ($1.2 million in tenant improvement allowances + $30,000 in moving expenses). Under ASC 840, these incentives have to be amortized over the lease term in a straight-line manner as well, which results in a monthly credit to rent expense of $10,082 ($1,230,000 / 122 months).
Note: To understand the accounting for tenant improvement allowances under ASC 840, read our blog on TI allowances.
As a result of the incentive adjustment, periodic rent expense on the income statement is $210,113 ($220,195 – $10,082).
How the rent-free period will be shown on the amortization schedule
The seven months of free rent are included on the amortization table, as they are necessary for the straight-line rent calculation. Below is a summary of the columns in the amortization table that are impacted by the free rent:
- Cash column: This is the exact amount paid out each month.
- Expense column: Expense must be evenly distributed throughout the lease term – straight-lined. Company divides the total payment amount by the number of months of the lease.
- Deferred rent: This is the difference between the expense incurred and the cash paid. In the first seven months, the company has free rent so the deferred rent amount is the total of the expense for the month.
Step 4: On the ASC 842 effective date, determine the total payments over the remaining lease term under the new lease accounting standard
For calendar-year private companies, the effective date of the new lease standard, ASC 842, is January 1, 2022. The transition entry is recorded on the date of transition, either from the earliest comparative period presented, or if companies utilize the practical expedient and do not present comparative financial statements, as of the transition date.
Most private companies will use the practical expedient, so we will do so in our example, and assume that the company is a calendar-year company. Therefore, the transition date for this company is January 1, 2022. The total remaining payments from January 1, 2022 through March 31, 2026 are $12,852,672.
Step 5: Calculate the operating lease liability (present value of the remaining lease payments)
Since the company is utilizing the transition practical expedient and not presenting comparative financials, under ASC 842, the company would need to calculate the present value of the remaining lease payments as of the transition date. The FASB says to use the rate inherent in the lease, however that rate is practically impossible for the tenant to determine. The FASB says if that rate is not determinable, then use the tenant’s borrowing rate. Well, what borrowing rate should you use? What date should you select the rate?
In our example, select the rate as of January 1, 2022, the transition date. If the company had not chosen to utilize the transition practical expedient, and is presenting comparative financial statements you would have used the borrowing rate as of 2021, not 2022.
The borrowing rate used is a very important distinction between ASC 840 and ASC 842. Under ASC 840, companies would use the rate at which it would have been able to borrow over a similar term the funds to purchase the leased asset. The guidance did not require companies to use a secured borrowing rate. As such, companies would often use a rate provided by Treasury that represented the company’s revolver rate. Under the ASC 842, companies must use the rate at which it could obtain funds to borrow on a collateralized basis over a similar term for this specific asset. These amounts could be very different (the funds to purchase the leased asset are usually much more than the payments over the lease term, especially for real estate leases).
In this example, the incremental borrowing rate is 9%, and payments are made at the end of the month. Using these facts and LeaseQuery’s present value calculator tool, the present value of the minimum lease payments is $10,604,260. This is the lease liability as of January 1, 2022.
Note: Click here to learn how to use Excel to calculate the present value of lease payments.
At this time, we want to make a very important point: The present value amount above ($10,604,260) is based on Excel. If you are recalculating this example using lease accounting software and you get that exact number above (payments are made in arrears), then we hate to tell you this, but your software is not entirely accurate.
This is because the software is assuming there is no interest paid in the first month of the lease. This issue means that your software is still using Excel in the background to make the calculation, which is not a good thing. The number you get should actually be slightly lower than the number above, once again because of interest paid in the first month.
When added together over multiple leases, this difference could be significant. You could be adding a much larger liability on your balance sheet if your software is calculating the liability this way. If you are using LeaseQuery, it calculates this amount accurately. Keep this in mind as you’re viewing demonstrations of lease accounting software from your choice of vendors.
Step 6: Calculate the right of use asset (with journal entry)
Per FASB’s lease accounting standard, the ROU asset is the liability calculated in step 5 above, adjusted by deferred rent and lease incentives. In this example, it is the liability of $10,604,260 plus the deferred rent balance as of December 2021, plus the unamortized incentive balance as of December 2021.
Below is a portion of the table from step 3 for the dates September 2021 through March 2022 to show how we arrive at the deferred rent balance and unamortized incentive balance as of 12/31/2021:
The formula for the ROU asset is the lease liability of $10,604,260 plus $1,622,743 (deferred rent as of December 2021) plus $514,180 (unamortized incentives as of December 2021). This gives us a total ROU asset of $8,467,336. The journal entry to record the ROU asset at transition would look like this:
After recording the ROU asset and lease liability as of transition, you would prepare an amortization table under ASC 842 to assist with the calculation of the periodic entries you will make moving forward. Below we have presented an amortization schedule as of the transition date for our private company.
This concludes the example showing how to transition from current to the new lease accounting rules.
Related articles
If you liked this post, consider reading these other blogs on lease accounting:
Thanks for the article! A quick clarification question, under step 6 it says “The formula for the ROU asset is the lease liability of $10,604,260 plus $1,622,743 (deferred rent as of December 2021) plus $514,180 (unamortized incentives as of December 2021). This gives us a total ROU asset of $8,467,336.” Am I correct to assume this should actually say ‘minus’ the deferred rent and ‘minus’ the incentive? The way it reads, it sounds like you are adding both of those items to the lease liability, however, based on the example and my understanding, these are subtracted from the lease liability, not added.
Hi Ryan,
Because the lease liability is a negative number to begin with, adding the positive amounts gives us a smaller liability. The lease liability is a credit of ($10,604,260) then we are adding, or debiting, the deferred rent of $1,622,743 and the unamortized incentive of $514,180 (an asset). Summing the lease liability and the two debits results in an ROU asset of ($8,467,336).
I have been using the straight-line amortization for 5 years and have a balance in my deferred rent. The company has decided to move to a smaller space in the same building. The lessor will cancel the lease and enter into a new lease with our company. How do I handle the accounting of the deferred lease amount?
Hey Brenda –
We are happy to assist. When the lessor cancels the initial lease, this will qualify as a lease termination. As the lessee, you will simply remove the full remaining balance of deferred rent at the termination date as a component of your termination journal entry. That amount will factor into the calculation of your gain/loss on termination.
If we can clarify further, please let us know!
Thank you for this article/tutorial. It is the first I’ve found online with a clearly illustrated example. Kudos.
Great learning material, thank you! I have a question, my company has several leases and we booked ROU Asset/Liabilities at adoption date Oct 2019. However, we just found out one lease we should book ROU A/L but we missed last Oct. Should I use Oct 2019 as adoption date for this missing lease, book all entries to bring the balance up to date this month, or use this month as adoption date and start fresh?
Thanks for the feedback! The correct way to account for the lease is to calculate what the entry would have been upon transition (Oct 2019), record in October 2019, and then continue making correcting entries until you have the correct balances as of today. However, this is probably not the most cost or time efficient method for adjustment. Therefore, the treatment of a lease that is missed in a reporting period will require professional judgment by your company. Certain things to consider:
1. Timing – You’ve indicated that the lease was not accounted for during the first year of adoption. If you haven’t released earnings/finished closing your fiscal year, you may consider opening up the period to disclose the impact of the lease liability and ROU asset for this lease as of the Oct 2019 date.
2. Materiality – Measure the present value of the remaining payments for this lease (as of Oct 2019 and currently) to assess whether the error is material enough to open the closed period (Oct 2019) or to make the correction in the current month. If you choose to make the correction in the current period, you would calculate the adjusting entry if the lease was recorded correctly in Oct 2019 and continued to be accounted for under ASC 842 until the current period.
Are Software renewal, Software maintenance/support agreement, and maintenance agreements in general are considered to be leased assets?
If there is no interest whatsoever and you are prepaying for the usage, will that still be considered leased asset and need to be recorded at present value? If yes, how?
Hi,
Thank you for your question. Generally, software support and maintenance agreements would not be considered leased assets, however, there could be embedded leases within the software agremeent. If there is an identfied asset and you have control of the asset, then you have a lease embedded within the agreement. Please see our embedded lease blog and embedded lease test for more information!
Blog- https://leasequery.com/blog/embedded-leases-asc-842-gasb-87-examples/
Free tool https://embeddedleasetool.leasequery.com/
How do we book the expense Journal entry?
Hello!
Thanks for your question. In booking the expense, even after transitioning to ASC 842 lessees still record a straight-line operating lease expense as they have done before.
In this example, the entry for the expense, for example, in Jan 2022, would look like this:
Debit Lease Expense 210,113
Debit Lease Liability 158,119
Credit ROU Asset 130,581
Credit Cash 237,651
The amounts come from the amortization table at the send of Step 6. The lease expense is the combined amount of liability lease expense and asset lease expense.
You may choose to reclass a portion of the liability in that entry as well from long term to short term. For further examples of this, please take a look below https://leasequery.com/video-gallery/asc-842-a-detailed-example-of-applying-the-new-lease-accounting-standards/.
In this example, I am trying to think through the deferred rent piece. Under 840, you would have a credit on your books of ($1,622,743) for deferred rent at 1/1/22 when you are transitioning. You show within the example above that a debit is made to the deferred rent account as a part of the ASC 842 transition entry for $1,622,743. This would lead to a zero balance within the deferred rent account after booking your transition entry.
Is it correct that there would be no monthly entry specific to deferred rent following the transition entry?
The only monthly entry would be:
Debit Lease Expense 210,113
Debit Lease Liability 158,119
Credit ROU Asset 130,581
Credit Cash 237,651
Please confirm that the above also holds true for the lease incentive.
Thank you.
Hi Jeff –
At transition, deferred rent balances roll into the ROU asset. Deferred rent is not recognized as a separate account or line item under ASC 42. This article Deferred Rent Accounting explains it more detail.
Do you include CAM charges in the lease calculation?
Thank you for your question. Whether to include/ exclude CAM charges in the lease calculation depends on if the payment is fixed or variable. Please see below:
Fixed payments- These payments are included in the present value calculation for the lease. Therefore, if the CAM payment is known and does not change throughout the life of the lease, then the CAM charges are likely fixed in nature, and should be recognized on the balance sheet.
Variable payments- These payments are expensed as incurred. If the CAM payment changes (i.e. monthly, quarterly, or annually) or if there is a reconciliation for the CAM payments, the payments are likely variable in nature. These payments should be expensed as they are incurred.
Great article, thank you!
One question – do private companies have the green light to adopt ASC 842 lease incentive accounting in 2020, prior to the 1/1/22 transition date? Or is it advised to follow ASC 840 accounting up until the transition date?
Absolutely. Private companies can elect to early adopt if they chose. Additionally, it is encouraged to start on the transition now instead of waiting becuase of the time and challenges faced by publicly companies who have already transitioned to ASC 842.
Great question!