- Accounting for an operating lease transition to ASC 842
- Determine the lease term under current GAAP
- Determine the total lease payments under GAAP
- Prepare the straight-line amortization schedule under current GAAP
- Determine total payments over the remaining lease term under the new lease accounting standard
- Calculate the present value of the remaining lease payments
- Calculate the right of use asset
The new lease accounting standards are significantly changing the accounting of 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 current US GAAP lease accounting 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.
Operating lease accounting example under ASC 842
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.
Note: The tenant will make journal entries for the operating lease using this amortization schedule through the effective date of the new 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
For public companies, the effective date of the new lease standard was January 1, 2019. 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, if you are using LeaseQuery software, 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 (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:
This concludes the example showing how to transition from current to the new lease accounting rules. If you liked this post, consider reading another one of our blogs, ASC 840 vs. ASC 842: Differences in the Old Lease Accounting Standard and the New.