- What is an operating lease?
- Changes to operating leases
- Identifying an operating lease
- Is lease capitalization required for all?
- Operating lease accounting example under ASC 842
What is an operating lease?
An operating lease is a contract where an owner of an asset (or lessor) gives someone (a 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. 1.) The term operating leases exists in both standards (though the accounting is different in each standard). 2.) Under ASC 840, there was a capital lease classification (which changed to the terminology finance lease in ASC 842), although 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 840 vs ASC 842: What is changing?
Under the old lease accounting standard, ASC 840, operating leases were considered off-balance sheet transactions. The expense associated with the arrangements was recognized in the income statement, but there was not any balance sheet impact. This made is difficult to understand the volume of commitments a company had entered into, and could 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 specifically, ASC 842 requires recognition of a right of use (ROU) asset and a corresponding lease liability upon lease commencement.
How do you identify an operating lease under ASC 842?
Lease classification under ASC 842 is relatively similar to ASC 840, although 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.
Transference of title/ownership to the lessee
Transfer of ownership of the underlying asset to the lessee by the end of the lease term.
Lease arrangement grants the lessee an option to purchase the asset, that is reasonably certain to be exercised.
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).
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 of the fair value of the underlying asset. 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).
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 under ASC 842
Details on the example lease agreement:
First, assume a tenant signs a lease document with the following predicates:
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.
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.
The tenant also received a reimbursement of $30,000 in moving expenses from the landlord.
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%.
Assume that the lease is classified as an operating lease, that the tenant is a public company, 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 incremental borrowing rate would be 6% in 2016 and 9% in 2019.
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, and more, 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 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 $220,194.68. See below for a screen shot of the straight-line amortization schedule.
Note however, that there is a total incentive of $1,230,000 ($1.2 million in Tenant Improvement Allowances and $30,000 in moving expenses). 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 $10,081.97.
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, total rent expense on the income statement is $210,112.71.
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 amount is the total of the expense for the month.
Step 4: On the effective date, determine the total payments over the remaining lease term under the new lease accounting standard
For public calendar year companies, the effective date of the new lease standard, ASC 842, was January 1, 2019. 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 public companies have used 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, 2019. The total remaining payments from January 1, 2019 through March 31, 2026 is $21,366,091.
Step 5: Calculate the 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, you would select your rate as of January 1, 2019, your transition date. If the Company had not chosen to utilize the transition practical expedient, you would have used the borrowing rate as of 2017, not 2019.
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 interest rate used would be 9%, and the present value of the minimum lease payments would be $15,208,446. This is the lease liability as of January 1, 2019.
Below we have presented an amortization schedule as of the transition date for our public company:
At this time, we want to make a very important point: The number calculated above ($15,208,446) 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 asset (with journal entry)
Per FASB’s lease accounting standard, the ROU asset at transition is the liability calculated in step 5 above, adjusted by deferred rent and lease incentives. In this example, it is the liability of $15,208,446 plus the deferred rent balance as of December 2018, plus the unamortized incentive balance as of December 2018. So the formula for the ROU asset is the lease liability of $15,208,446 plus $1,843,076 (Deferred rent as of December 2018) plus $877,131 (unamortized incentives as of December 2018). This gives us a total ROU asset of $12,488,239. 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, New Lease Accounting Standards: Summary of FASB ASC 842, IFRS 16, and GASB 87.