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.
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.
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.
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.
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.
The following is a full example of how to transition an operating lease from ASC 840 to the new standard, ASC 842.
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. 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.
The tenant also received a reimbursement of $30,000 in moving expenses from the landlord.
Per the lease document, rent is due beginning 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 rent commencing of 3%.
Assume that the lease is classified as an operating lease and the fair value of the building is $300 million. Assume the tenant opened for business at the location on June 1, 2016. Assume the tenant is a private company with a calendar year-end and will transition to ASC 842 on January 1, 2022. Assume that the rate implicit in the lease is unknown and the tenant’s incremental borrowing rate is 6% on September 1, 2016 and 9% on January 1, 2022.
Here are the steps to take to correctly transition the above lease from ASC 840 to ASC 842 accounting:
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.
The tenant will begin paying rent on September 1, 2016 (3 months from the date the tenant opened for business). The total lease payments are $26,863,751.
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 first months’ straight-line amortization schedule under ASC 840..
The tenant must also account for the 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). As a result of the incentive adjustment, periodic rent expense on the income statement is $210,113 ($220,195 – $10,082).
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 is shown on the amortization schedule
The seven months of free rent are included on the amortization table to show the complete straight-line rent calculation. Below is a summary of the columns in the amortization table impacted by the free rent:
- Cash Payment: This is the exact amount paid out each month.
- Expense: Expense must be evenly distributed throughout the lease term – straight-lined. The tenant divides the total payment amount by the number of months in the lease term.
- 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.
- Deferred Rent Balance: This is the cumulative difference between the expense incurred and the cash paid. As the expense is greater than the payment the balance increases and when the expense is less than the payment the balance decreases until it is $0 at the end of the lease term.
For calendar-year private companies, the effective date of 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 elect to use the practical expedient to not present comparative financial statements, so our example will as well. 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.
Since the company elected to not present comparative financials, they must calculate the present value of the remaining lease payments as of their transition date. FASB guidance requires private entities to use the rate inherent in the lease, unless that rate is not readily determinable. If the implicit rate is not determinable, the tenant has the option to use their incremental borrowing rate or a risk-free rate.
In this example, the tenant opts to use their incremental borrowing rate of 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 remaining lease payments is $10,604,260. This is the lease liability as of January 1, 2022.
Note: 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 your software is not entirely accurate.
This is because the software is assuming no interest is 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.
Per FASB’s lease accounting standard, the ROU asset is the liability calculated in step 5 above, adjusted by prepaid or 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 clears the outstanding deferred rent and lease incentive amounts to the ROU asset and would look like this:
After recording the ROU asset and lease liability as of transition, the tenant would prepare an amortization table under ASC 842 to assist with the calculation of the periodic entries moving forward. Below is the amortization schedule for the lease in the example as of the transition date for a private company.
This concludes the example of how to transition a private company from ASC 840 to ASC 842.
If you liked this post, consider reading these other blogs on lease accounting: