What is an operating lease?
Putting it simply, an operating lease is a contract that provides a lessee the right to use an asset without the benefits of ownership. Under topic 840, operating leases did not need to be recorded on the balance sheet – they didn’t meet the criteria required for a lease to be capitalized.
The requirements for lease classification remain largely unchanged under ASC 842, except that the FASB eliminated the bright–lines in the rules, that is, the 75% of lease term and 90% of FMV rules are no longer hard and fast. Additionally, there is a new fifth test you must perform, instead of the original four. This change is primarily due to the fact that the board is moving away from “rules” based accounting to “principle” based accounting.
How has accounting for operating leases changed under ASC 842?
ASC 842 represents a major shift in the way you account for operating leases. With all leases with terms longer than 12 months going on the balance sheet, you must completely rethink the way you account for them. In this blog, we’ll summarize everything you need to know about the new guidance on accounting for operating leases.
For most leases, the ROU (right of use) asset and the lease liability will be equal upon lease commencement:
If you have an operating lease without initial direct costs, prepaid/deferred rent, and without a tenant improvement allowance (or some other lease incentive), then the ROU asset and the lease liability will be equal on the lease commencement date. The entry will simply be a debit to the ROU asset and a credit to the lease liability. This is the same for finance leases. Click here for a summary of Finance(Capital) leases under topic 842.
Initial lease liability calculation
The initial Lease Liability for operating leases under the new lease accounting rules is calculated as the present value of the minimum lease payments discounted using the borrowing rate of the lessee. To learn how to use Excel to calculate the present value of minimum lease payments, click here. Please note that the initial lease liability for operating leases is calculated in the EXACT same way as the initial lease liability for finance leases. However, unlike finance leases, the lease liability for operating leases is NOT considered debt.
Initial ROU asset calculation
The initial ROU (right of use) asset for operating leases under the new lease accounting rules is the initial lease liability as calculated above, plus any prepaid lease payments and initial direct costs, less any lease incentives (for instance, tenant improvement allowances) received prior to the lease commencement date. Please note that the initial ROU Asset calculation for operating leases is calculated in the EXACT same way as the initial ROU Asset calculation for finance leases. Click here for a summary of finance leases under the new lease accounting rules.
Subsequent lease liability calculation
Subsequent values of the lease liability are determined via accretion using the effective interest method, similar to other financial liabilities. Like any other loan amortization schedule, a portion of the payments each period goes to liability reduction, and the remainder goes to lease expense. Please note that UNLIKE finance leases, where a portion of the payments goes to debit interest expense, under operating leases, lease (or rent) expense is debited. That said, while the subsequent lease liability calculations are the same under finance and operating leases, the entries made are different (Finance leases require entries to Interest Expense, while Operating leases require entries to Rent Expense).
Subsequent ROU asset calculation
The ROU asset is amortized as the difference between “average rent” and lease (or rent) expense from the liability. Average rent is simply straight line rent expense under topic 840 for operating leases. Note that unlike finance leases, the amortization of the ROU asset for operating leases is NOT deemed depreciation expense. Just like the amortization of the liability under operating leases, it is also called “Lease (or Rent) Expense.” As a result, rent expense for operating leases is recorded on a single line item for operating leases; but a portion comes from the liability and the other piece comes from the ROU asset. The total effect on the income statement is “average rent,” which is the same effect operating leases have on the income statement under topic 840.
Operating leases under topic 842 will not change the Income Statement, EBITDA, or Debt:
Operating leases are currently amortized via straight-line on the income statement. Under topic 842, operating leases will also be amortized straight-line, via “average rent,” which means there is no change to the income statement under topic 842 operating lease rules versus operating leases under topic 840. In addition, under topic 842 for operating leases, amortization of the lease liability and the ROU asset are NOT considered interest expense or depreciation expense respectively, and as a result EBITDA is not changed under operating leases for topic 842 versus operating leases under topic 840. Finally, the lease liability resulting from operating leases is not considered debt, which means debt is also unchanged when comparing topic 842 operating leases to operating leases under topic 840. The chart above is a simplified diagram summarizing the effect of finance and operating leases on Net Income, EBITDA, Debt and the Balance Sheet.
There you have it. That’s basically a summary of operating leases per topic 842. We’ve followed up with an additional article, a comprehensive example of an operating lease under topic 842 using actual numbers.
LeaseQuery is lease accounting software that helps companies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc.), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A.
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