What is lease liability and how is it calculated?
In accounting, a lease liability is a financial obligation to make the payments arising from a lease, measured on a discounted basis. Lease liability is calculated using the present value of the lease payments over the lease term discounted, typically, using the lessee’s incremental borrowing rate.
Under ASC 842, the initial lease liability is calculated in the exact same way for both operating leases and finance leases.
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What is the right-of-use asset?
In accounting, the right-of-use asset (ROU asset) arises from a lease agreement and represents the lessee’s license to hold, operate, or occupy the leased property or item over the lease term.
How do you calculate the right-of-use asset?
The ROU asset is calculated with the following steps:
- The initial amount of the lease liability
- Plus lease payments made before lease commencement
- Plus initial direct costs
- Less any lease incentives
Similar to the lease liability, the initial right-of-use asset calculation for operating leases is identical to that of finance leases.
ROU asset amortization period
The ROU asset is amortized from the lease commencement date (the date the lessee begins to make payments) to the end of the lease’s term. In some cases, it may be from the commencement date to the end of the useful life of the asset.
The ROU asset and operating leases
An operating lease is a contract that provides a lessee the right to use an asset without the benefits of ownership. Under FASB ASC 840, operating leases did not require a lease asset and liability to be recorded on the balance sheet – they didn’t meet the criteria for capitalization.
The requirements for lease classification remain largely unchanged under ASC 842, with the following changes:
- The second test no longer evaluates if a bargain purchase option exists, but if the lease contains an option to purchase the asset that the lessee is reasonably certain to exercise
- The 75% of lease term and 90% of FMV rules are no longer definitive. However, the FASB has suggested that companies should continue to use these thresholds in their analyses, unless there is a more appropriate threshold based on the company’s facts and circumstances. The company needs to develop an overall policy with regards to these thresholds that it uses consistently.
- There is a new fifth test – you must consider whether or not the asset is specialized in nature and has a future value to the lessor.
These changes are primarily due to the fact that the board is moving away from “rules” based accounting to “principle” based accounting.
Changes to operating lease accounting under ASC 842
ASC 842 represents a major shift in the way lessees account for their operating leases. Aside from the ability to take advantage of a policy election that would allow a lessee to account for leases with terms shorter than 12 months similar to an operating lease under ASC 840, all operating leases must be recognized on the balance sheet with a lease liability and ROU asset, calculated at initial recognition as discussed at the beginning of the article.
Note: Read a summary of everything you need to know about the new guidance on accounting for operating leases.
The ROU asset and finance leases
Accounting for finance leases under ASC 842 is largely unchanged compared to ASC 840. Under the old standard, lessees were required to record a lease asset and liability for capital leases. The same is true under the new standard.
For basic leases, the ROU asset and lease liability will be equal upon lease commencement. For example, if a company has a 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 for the present value of the lease payments.
Subsequent lease liability calculation and journal entries
We will highlight the differences in subsequent accounting treatment for finance and operating leases.
For finance leases, a portion of each periodic payment represents interest expense and the remainder is a reduction of the lease liability. Subsequent values of the lease liability are determined via accretion using the effective interest method, similar to other financial liabilities.
For operating leases, a single lease expense — also known as a rent expense — is recognized each period on a straight-line basis.
Subsequent ROU asset calculation
Concerning the ROU asset, the difference between finance and operating leases lies in 1) whether or not the amortization of the asset is deemed depreciation expense and 2) the calculation of the periodic entry.
For finance leases, the ROU asset is amortized on a straight-line basis over the term of the lease. This is recognized as depreciation (or amortization) expense.
The amortization of the ROU asset for operating leases is not recognized as depreciation expense. For example, in a basic lease (without any incentives, etc), each period, the asset is reduced by the same amount as the liability reduction.
There will be no effect to the income statement, EBITDA, or debt
Under ASC 840, operating lease expense was recognized on the income statement using the straight-line method. Under 842, the lease expense will continue to be recognized as a single lease expense, straight-line. This means that the transition to the new lease standard for an operating lease will not affect the income statement. Because the lease liability expense is a single expense, interest expense is not calculated for this type of lease, and as a result EBITDA is not changed. Finally, the lease liability resulting from operating leases is not considered debt*, which means debt is also unchanged. The chart below is a simplified diagram summarizing the effect of finance and operating leases on net income, EBITDA, debt and the balance sheet.
Note: This is different from IFRS 16, which will have an impact on debt.
Impact of lease liabilities on the balance sheet
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This comprehensive guide on understanding the ROU asset as it relates to both finance and operating leases should help you in your future calculations. If you’re unsure what type of lease you have, we offer a number of free tools for lease accounting that can help you. To learn more, visit our Features page or schedule a LeaseQuery demo today.
Related articles: Full examples of calculating the ROU asset and lease liability
These two articles provide full examples of the correct accounting for finance leases and operating leases under ASC 842: