Here are the steps to transition an operating lease from current GAAP to ASC 842:
- Identify remaining lease term (from the beginning of the earliest comparative period presented)
- Identify remaining payments over remaining lease term from Step 1
- Calculate present value of remaining payments from step 2 over remaining lease term using discount rate as of effective date (This is the Lease Liability)
- Adjust amount in Step 3 for any prepaid or deferred rent (this is the ROU asset)
Operating lease example
Consider the following scenario:
- 10-year lease commenced January 1, 2015
- Annual payments of $10,000/yr in years 1 through 5 (paid in arrears), and $15,000/yr in years 6 through 10
- Transition date is January 2019. Incremental borrowing rate on transition is 6%
- 3-year comparative period displayed in Income and cash flow statements (So this is a publicly traded company. Private companies would only have 2-year comparative periods).
Step 1: Identify the remaining lease term (from the beginning of the earliest comparative period presented):
In 2019, the income statements displayed will be for 2019, 2018 and 2017, so the earliest comparative period presented is 2017. From 2017, the remaining lease term is 8 years.
Step 2: Identify remaining payments over remaining lease term (from the beginning of the earliest comparative period presented):
The remaining payment schedule is as follows:
Step 3: Calculate present value of remaining payments over remaining lease term using discount rate as of effective date (this is the lease liability)
Lease liability amortization schedule of remaining payments is as follows:
To see my blog on how to calculate the present value of lease payments, click here. Please note that this means that the lease liability is 79,782.
Step 4: Adjust amount in Step 3 for any accrued or deferred rent (this is the ROU asset)
The following is the (previous) straight line amortization schedule for the lease under the current accounting rules for operating leases:
You can see that the deferred rent balance as of January 2017 is $5,000. So the ROU asset balance is:
79,782 – 5,000 = 74,782.
If making an entry in January 2017, it would be:
Journal entry at earliest comparative period
Dr ROU Asset 74,782
Dr Deferred Rent 5,000
Cr Lease Liability 79,782
The lease liability will be amortized based on the lease amortization schedule from Step 3 above (a portion of each payment goes to interest expense, and the balance reduces the lease liability). So in 2017, a payment of $10,000 will be made; $4,787 will be allocated to Interest Expense, and the lease liability will be reduced by $5,213.
Here are the steps to go from current GAAP to an operating lease under the new lease accounting standard (ASC 842):
Also, remember to read our blog titled “Finance and Capital Lease Accounting: A Comprehensive Example” to learn more about capital and operating leases. We also offer a free tool you can use to determine whether a lease is a capital or operating lease.