This blog is made up of two parts. The is a summary of the three lease accounting standards and explains their differences. The second is a comprehensive example of transitioning an operating lease from current GAAP to the new lease accounting standard, ASC 842. We will be using a real life scenario that one of our clients graciously allowed us to use as an example. To skip straight to the example, click the link below.
For two full examples of how to transition under IAS 17 and IFRS 16, click here.
Lease accounting standards summary
For financial reporting, companies need a set of guidelines, or accounting standards, to accurately reflect the amount, timing, and uncertainty of cash flow of the business. GAAP, IAS, and IFRS are accounting standards created to aide in the distribution of financials. Here are the differences between the three lease accounting standards:
GAAP (Generally Accepted Accounting Principles)
GAAP was issued in 1973 by the Financial Accounting Standards Board (FASB) for US public companies and private companies issuing public statements. The accounting standards under GAAP are rule-based, meaning they are more strict or explicit in what is understood for accounting treatment and financial reporting.
IAS (International Accounting Standards)
IAS was also issued in 1973, but by the International Accounting Standards Committee (IASC) in London. This was created under the grounds that it would serve as a set of world-wide standards for both listed and unlisted companies across various countries. In April of 2001, the IASC restructured itself and lead to the emergence of the International Accounting Standards Board (IASB).
IFRS (International Financial Reporting Standards)
IFRS was issued starting in 2001 after the development of the IASB. The IAS elected that it would adopt the older standards of the IAS, but moving forward, all international standards published by IASB would be called IFRS. The accounting standards under IFRS are principle-based, which leaves more room for interpretation.
Note: IFRS & IAS have been condensed into a single column as they are treated the same way in practice.
Both FASB and IASB convened together, in 2012, to create the new standards for treatment of leases. While there are various, minor differences between the two standards, it was unanimous that all leases would be reflected on the balance sheet.
Click here for a full summary of the new lease accounting standards, ASC 842 and IFRS 16. For additional information on how to transition, please refer to LeaseQuery’s in-depth guide to the lease accounting changes.
Operating lease accounting example under ASC 842: How to transition
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. 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.
TI Allowance: The tenant received a 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, assume that the tenant is a public company, assume that the rate inherent 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 borrowing rate would be 9% in 2019 and 6% in 2017.
Here are the steps to take to transition from current GAAP to the new lease accounting standards issued by the FASB:
Step 1: Determine the lease term under current GAAP.
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, 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 See image below.
Step 3: Prepare the straight-line amortization schedule under current GAAP.
The lease term is 122 months (from Step 1), total rent is $$26,863,751 (from step 2). Monthly rent expense from base rent is therefore $220,194.68.
Note however, that there is a total incentive of $1,230,000 ($1.2 million in TI allowances and $30,000 in moving expenses). These incentives have to be amortized over the lease term as well, which results in a monthly credit to rent expense of $10,081.97.
Note: To understand the accounting for tenant improvement allowances under current GAAP, click here.
As a result of the incentive adjustment, total rent expense on the income statement is $210,112.71. See below for a screen shot the straight-line amortization schedule that was taken directly from our lease accounting system.
Note: the tenant will make journal entries for the operating lease using this amortization schedule through the effective date of the new lease accounting standard.
How the rent free period will be shown on the amortization schedule
Let’s use an example to explain the amortization schedule with free rent. Company QRS is leasing a forklift for 7 years with total payment of $470,000. In the first 2 years the company will make monthly payments of $5,000; however, the first 2 month will be free. Please refer to the table directly below for reference.
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 QRS divides the total payment amount by the number of months of the lease. [$470,000/84 = $5,595.24]
Deferred Rent: This is the difference b/w the expense incurred and the cash paid. – in the first month Company QRS had free rent so the deferred amount is the total of the expense for the month.
Cumulative Balance: This is simply the accumulation of deferred rent each month.
Step 4: On the effective date, determine the total payments over the remaining lease term under the new lease accounting standard.
The new lease accounting standard effective date for public companies is January 2019 (January 2020 for private companies), and the remaining lease term starts from the earliest comparative period presented. Public companies issue 3 income statements and 3 cash flow statements, as such the earliest comparative period presented would commence on January 1, 2017. The total remaining payments from January 1 2017 through March 31, 2026 is $26,043,751.
Step 5: Calculate the present value of the remaining lease payments (the lease liability).
Under the FASB’s new lease accounting standard, the company would need to calculate the present value of the remaining lease payments from the earliest comparative period presented. 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? Do you use the rate as of 2017 or 2019?
In this scenario, you would use the borrowing rate as of 2017, NOT 2019. This brings us to a very important distinction between current GAAP and the new lease accounting standards. Under current GAAP, companies would use the rate at which it could obtain the funds to purchase the entire leased asset.
Under the new standards, companies would use the rate at which it could obtain funds to pay for the lease payments over the lease term. 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 then, the interest rate used would be 6%, and the present value of the minimum lease payments would be $19,797,618. This is the lease liability as of January 1, 2017.
At this time, we want to make a very important point: The number calculated above (19,797,618) 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 advance), then we hate to tell you this, but your software is not entirely accurate.
This is because the software is assuming that 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. Obviously, LeaseQuery software calculates this amount accurately. Keep this in mind as you evaluate lease accounting software.
Step 6: Calculate the Right of Use (ROU) Asset.
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 19,797,618, less the deferred rent balance as of December 2016, less the unamortized incentive balance as of December 2016. So the formula for the ROU asset is 19,797,618 minus 1,602,141 (Deferred rent as of December 2016 – See Step 3 Image) minus 1,119,098 (unamortized incentives as of December 2016 – see step 3 image). This gives us a total ROU asset of 17,076,379. If this were a journal entry, it would look like this:
There you have it. That is a comprehensive example showing how to transition from current to the new lease accounting rules.
As always, we write detailed blogs like this to demonstrate that our experts at LeaseQuery are lease accounting experts, not just real estate professionals. We fully understand the challenges faced not just by real estate and equipment leasing professionals, but also the accounting departments who support both of those groups. Our lease accounting and lease management software reflects our expertise.
If you liked this post, consider reading the following: ASC 840 vs. ASC 842: Differences in the Old Lease Accounting Standard and the New