This blog is made up of two parts. The first section provides an overview of the three lease accounting standards and explains their differences. The second is a comprehensive example of how to transition from current GAAP to the new lease accounting standards. We will be using a
*Editor’s note 3/20/18: we have updated this article for clarity and consistency. Additionally, we had a reader ask for a clarification of how rent free period will be shown on the amortization schedule, which is included after step 3.
For two full examples of how to transition under IAS 17 and IFRS 16, click here.
Lease accounting standards overview
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
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.
International Accounting Stands (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
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.
For further questions, please refer to LeaseQuery’s in-depth guide to the lease accounting changes or on lease accounting divergence. As always, contact us for any of your burning lease accounting questions. The changes to the lease accounting standards occur this year, so schedule a demo of LeaseQuery today!
Example: how to transition from current GAAP to new standards
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 3 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,
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
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. Please see below for an illustration of the straight-line amortization schedule, note that this is a
Hi. Can you show an example
Let’s use an example to explain the amortization schedule with free rent. Company QRS is leasing a forklift for 7 years with
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
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.
Under FASB’s new lease accounting standard, the effective date for public companies is January 2019, 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
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.
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. So if this were a journal entry, it would look like this:
Dr ROU Asset 17,076,379
Dr Deferred Rent 1,602,141
Dr Lease Incentive 1,119,098
Cr Lease Liability 19,797,618
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 not just real estate professionals, but also lease accounting experts. Trust us, there’s a difference. We understand the challenges faced not just by real estate and equipment leasing professionals, but also the accounting departments supporting both groups. Our lease management software reflects our expertise.
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