Lease accounting is the method by which organizations account for their leasing contracts – whether lessors or lessees – on their balance sheets. The reporting standards for lease accounting are maintained by the Financial Accounting Standards Board (FASB) in the United States, International Accounting Standards Board (IASB) internationally, and the Governmental Accounting Standards Board (GASB) for state and local entities in the United States.
That’s the short version of the definition of lease accounting. But after the release of ASC 842, IFRS 16, and GASB 87, there’s a whole lot more to it. One of the major changes with the new standards is that lessees must capitalize most of their leases.
A major misconception with the new lease accounting standards is that capitalizing your leases can be boiled down to one simple calculation: net present value. The reality is that calculating your net present value is just the start.
What do the new standards really require of you?
The impetus behind the standard change was to enhance transparency into financial obligations. Leases have long been a blind spot in that category. Each of the standards require companies to bring most leases onto the balance sheet. Before you begin preparing your financial reports, you need to get a deeper understanding of what the standards call for.
Beyond present value: a closer look at lease accounting calculations
There is a complex set of calculations you have to complete in order to be fully compliant. Beyond net present value, you also need to calculate:
Lease liability amortization schedule
Lease liability is the present value of your future lease payments and is recorded alongside the right of use asset for operating and finance leases. Under ASC 842, your lease liability is not considered debt. Under IFRS 16 and GASB 87, however, lease liability is considered long-term debt. It’s important to know how to properly calculate the liability amortization schedule whether you plan to use Excel or a lease accounting software. The more you know, the better you’re able to ensure that the calculation is accurate.
Right of use asset
The right-of-use asset, or ROU asset, is a lessee’s right to use an asset for the life of a lease. Under ASC 842, the ROU asset is calculated as the lease liability amount and any lease prepayments plus any direct costs, less any lease incentives. For IFRS 16, however, a lessee must calculate depreciation of the ROU asset and interest on the lease liability. With GASB 87, ROU assets and lease liabilities are presented separately on your balance sheet.
Straight-line rent expense
The concept of straight-line rent expense requires lessees to charge their total lease liability to expense on an even, periodic basis over the lifetime of the contract. Similar to straight-line depreciation — an easy method of calculation, this method is required to evenly recognize a fixed asset over its useful life — straight-line rent expense is calculated by aggregating all rent payments and dividing them by the full contract term.
When it comes to ASC 842 and IFRS 16, determining the right discount rate can be tough. It’s important to use the rate implicit in the lease. If you’re unsure about the discount rate after combing through the lease, there are ways to determine the rate on your own. First, determine the fair value of the asset at the beginning and end of the lease, and what your payments are. Then, use that information to conduct a present value calculation. If you don’t know or are unsure about the fair value of the asset, you would then use the incremental borrowing rate. If you’re a private company and cannot find any of the rates above, you can use the risk-free rate.
In addition to the calculations outlined above, you’ll also need to consider the liability reduction, asset lease expense, the weighted average discount rates for operating and finance leases (under ASC 842), and the weighted average lease term for finance and operating leases (under ASC 842).
Beyond these items, you’ll need to consider the necessary disclosures that use these calculations but report on them in different ways.
Decisions you need to make
The new standards require you to do more than just crunch the numbers, because they represent a shift from rules-based accounting to principles-based accounting. That shift means you need to start making judgment calls. It’s one of the mental hurdles you’ll need to overcome in order to comply.
Some of those decisions include:
- Whether you will have a materiality threshold to determine which leases will go on the balance sheet
- Whether you will elect practical expedients under ASC 842 or IFRS 16 – some can be elected company-wide, while others can be elected by class of asset
- The method you’ll use to determine discount rate
Don’t miss the opportunity the new standards provide
There is an opportunity to do more than simply comply. Transitioning to the new standards offers you the chance to develop better insights into a variety of key metrics by enabling you to:
- Project costs by reporting location or business segment
- Gauge how the new standards will impact your debt covenants
- Report on your leases based on allocation or segment
- Work more collaboratively with leasing departments to help them perform lease vs buy analysis
The depth of complexity of the new standards can’t be understated. By rethinking the way you look at leases, you have an opportunity to think more critically about how you account for them and their impact on your business.
With so many recent regulation changes it can be easy to develop regulatory fatigue. Changing the way you think about these new regulations will set you up for compliance in the short term and support your career development in the long term.