This post is made up of two sections. The first is an overview of the facts regarding the right-of-use (ROU) asset and operating leases under ASC 842, the new lease accounting standard. The second is a full example how to account for an operating lease under ASC 842.
- What is an operating lease?
- Accounting changes for operating leases under ASC 842?
- Right of use asset and lease liability for lease commencement
- Lease liability: definition and how to calculate initial lease liability?
- Initial ROU asset calculation
- Subsequent lease liability calculation
- Subsequent ROU asset calculation
- Operating leases under topic 842
What you need to know about the ROU asset and operating leases under the new lease accounting rules
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.
What is lease liability and how do you calculate initial lease liability?
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. The lease liability for operating leases is not considered debt, but it is calculated in the exact same way as the initial lease liability for finance (capital) leases.
Learn how to use Excel to calculate the present value of minimum lease payments or download our free present value calculator:
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.
Operating lease accounting example for lessees: how to transition to ASC 842
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)
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:
Please note that this means that the lease liability is 79,782.
Read our blog on how to create the lease amortization schedule or download our free net present value calculator:
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
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.