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Lease Accounting

January 21, 2022

The Financial Accounting Standards Board (FASB) issued the lease accounting standard ASC 842 on February 2016, and the new standard will come into effect for most private companies in the fiscal year beginning after December 15, 2021. Because the changes in the accounting treatment may have an impact on the company’s balance sheet, we will provide a summary of what these changes are in this newsletter.

■Defining the Lease

The new lease accounting standard defines a lease as “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”

Under ASC 842, leases are classified as either an operating lease or finance lease. Finance lease replaces the previous classification of capital lease. A lease will be classified as a finance lease if any of the below five criteria are met:

  1. Lease ownership is transferred to the lessee by the end of the lease term.

  2. Purchase option of the asset is provided to the lessee, and it is reasonably certain to be executed

  3. Lease term encompasses major part of the remaining economic life of the asset

  4. Present value of lease payments plus residual value guaranteed by the lessee is greater than or is equal to substantially all the fair market value of the asset

  5. The asset is so specialized that it is only useful to the lessee without major modifications.

■Changes in the Accounting Treatment

The most significant change of ASC 842 is in the requirement for lessees to recognize the right-of-use (ROU) asset – the lessee’s right to use an asset – and the liability of leases – the financial obligation over the lease term – on the balance sheet at lease commencement, when the asset is made available for use to the lessee. As opposed to finance leases, operating leases were previously not included on the balance sheet, but companies must now calculate both the ROU asset and lease liability and report on the balance sheet.

■Examples for the New Lease Standard

To explain the differences between the two leases and the accounting treatment under the new standard, we will go through how journal entries are recorded for both an operating lease and financing lease under the same conditions as listed below.

  • Lease term: 3 years (1/1/2022 – 12/31/2024)

  • Initial direct cost paid at commencement: $8,000

  • Lease payments: $100K, $110K, $115K (total $325K)

  • Timing of payment: end of each year

  • Discount rate: 5%

The journal entries recorded at the beginning of the lease and at end of each year is shown in the next page. We will use these entries as examples to show how each component of the lease is calculated.

■Journal Entries Recorded for the Lease Examples

■Entry at Lease Commencement: Recognizing ROU Asset and Lease Liability

At the lease commencement, the ROU asset and lease liability are first calculated and recorded on the balance sheet. Lease liability is calculated as the present value ($294,353) of all future lease payments ($325,000), using the discount rate of 5%. In the new standard, the rate implicit in the lease must be used as the discount rate. If such rate is not mentioned in the contract, the lessee may elect to use the lessee’s borrowing rate (the rate of interest that a lessee would pay to borrow an equal amount) or the risk-free rate (most often provided by the Treasury).

The ROU asset is measured as the sum of the lease liability and any initial direct costs or prepaid lease payments. Because the initial direct cost paid at the beginning of commencement is $8,000 and the lease liability is $294,353, the ROU asset recorded at commencement is $302,353. If there were no initial costs incurred, then the ROU asset will be equal to the lease liability of $294,353.

■Entry at End of Year 1: Recognizing Amortization and Interest Expense

At end of each year amortization and interest expenses are recorded, and the ROU asset and lease liability are adjusted accordingly. Both operating and finance lease require the amortization of ROU assets over the lease term and the calculation of interest expense from the lease liability; however, whereas amortization and interest expense must be classified separately for a finance lease, the two may be recorded as a single “lease expense” for an operating lease (though companies may elect to separate them).

In an operating lease, the lease expense is calculated on a straight-line basis over the lease term similarly to the previous standard. Thus, the lease expense recorded each year for an operating lease will be $110,000, which is a third of the total payment of $333,000. This is also equal to the sum of interest expense and amortization expense. Interest expense, calculated from the discount rate (5%) and lease liability balance ($294,353), is $14,718. The amortization expense for an operating lease is simply calculated as the difference between the lease expense and interest expense, which is $96,282. The change in lease liability is recorded as the difference between the cash payment ($100,000) and value of interest expense ($14,718), and the change in ROU asset is equal to the value of amortization expense ($96,282).

In a finance lease, the amortization expense, not the lease expense, is calculated on a straight-line basis. Thus, the amortization expense and the adjustment of ROU asset recorded each year for a finance lease will be $100,784, which is a third of the ROU asset recorded at commencement ($302,353). The calculation of interest expense and adjustment of lease liability is the same as an operating lease.

Amortization and interest expense are calculated in the same manner in Year 2 and 3.

■Understanding the Impact to the Balance Sheet

The tables below summarize the entries recorded each year and the asset and liability balance.

Note that the beginning ROU asset and lease liability are the same, and the total interest and amortization expense recorded are also the same. But because amortization expense and the total lease expense are calculated differently within the lease term, the ROU asset balance at a given point in time will differ between the two types of leases. When applying the new lease standard, it is highly recommended to create a schedule for the entire lease term and calculate the different components of the lease.

The explanations up till now have focused on the changes for the lessees, but the accounting treatment for lessors has not changed significantly in the new standard. Lastly, the new standard does allow companies to elect to not recognize lease assets and liabilities for short-term leases (12 months of less) that do not provide options to purchase the asset that the lessee is reasonably certain to exercise. During the transition to the new standard, companies are recommended to list out the existing leases, understand the nature of the leases and their conditions, and set consistent policies to follow the guidelines of the new lease standard.


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