While the adoption deadline for accounting standards update (ASU) No. 2016-02, Leases (Topic 842), might seem far enough away to relegate this topic as tomorrow’s problem, given that the topic must be applied retrospectively for comparative financial statements and that time is needed to plan and execute implementation, your best bet is to begin planning for implementation today.
As a friendly reminder, ASU 2016-02 is effective for public entities for fiscal years beginning after December 15, 2018, and for privately held entities for fiscal years beginning after December 15, 2019. Early adoption is permitted.
How do I calculate the lease liability and right-of-use asset?
The lease liability is calculated as the present value of the remaining minimum rental payments (RMRP) and any amounts probable of being owed by the lessee under a residual value guarantee. The right-of-use asset will equal the lease liability, adjusted for the following balances recorded under the previous lease accounting standard: prepaid or accrued rent, straight-line lease liability, or unamortized initial direct costs capitalized. The right -of-use asset is adjusted by these items so when the initial journal entry is made to record the lease liability and right-of-use asset, these items can be written off.
Included in the RMRP are (brace yourself—this is a mouthful!) fixed payments, variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), the exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option, and payments for penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease. Not included in RMRP are variable lease payments other than those depending on an index or a rate, any guarantee by the lessee of the lessor’s debt, and amounts allocated to non-lease components (defined as payments made for separate performance obligations such as maintenance service payments) of the agreement.
The present value calculation requires a discount rate, which is the rate implicit in the lease agreement unless that rate cannot be readily determined. In that case, lessees are required to use their incremental borrowing rate.
If the lease includes extension options or early termination options that are likely to be exercised, the lease term should include the option in the calculation of present value of RMRP.
For leases classified as capital leases under current lease accounting standards, the asset associated with the capital lease will be reclassified as a right-of-use asset (reported separately from other fixed assets).
Under ASU 2016-02, lessees and lessors are required to recognize and measure leases at the beginning of the earliest comparative period presented using a modified retrospective approach. The modified retrospective approach entails adjusting equity at the beginning of the earliest comparative period presented and disclosing the other comparative amounts for each prior period presented in the financial statements as if ASU 2016-02 lease accounting had always been applied. Therefore, it is necessary to calculate the lease liability and right-of-use assets not only for leases in effect or commencing in the year of adoption, but also for leases as of the prior period so the prior-period financial statements can be adjusted and presented comparably.
How are the lease liability and right-of-use asset accounted for in periods subsequent to adoption?
For operating leases, the lease expense is straight-lined over the lease term, and the right-of-use asset is amortized over the lease term by the difference between the straight-line lease expense and the interest expense.
Under a finance lease (capital leases under the current lease accounting standards), the right-of-use asset is amortized on a straight-line basis over the lease term. Therefore, the total lease expense will equal the interest expense plus the right-of-use asset amortization expense.
The lease liability will be amortized in the same manner for both operating and finance leases.
At the end of the lease term, the right-of-use asset should be fully amortized and the lease liability balance should be zero. It is recommended this outcome be double-checked prior to recording journal entries by calculating the entire amortization of the lease liability and the right-of-use asset.
Are there any implementation shortcuts?
The new standard allows for the election of up to three practical expedients, which will help alleviate time spent implementing Topic 842. The first practical expedient, which must be elected as a package, negates the need to reassess whether any expired or existing contracts are or contain leases, the lease classification for any expired or existing leases, and any initial direct costs for any existing leases. The second practical expedient allows for the use of hindsight in determining the lease term (that is, when considering lessee options to extend or terminate the lease and to purchase the underlying asset) and in assessing impairment of the entity’s right-of-use assets. This practical expedient may be elected separately or in conjunction with the first practical expedient. Under the third practical expedient, lessees are not required to separate non-lease components from lease components. These practical expedients must be applied consistently to all leases.
Proposed ASU No. 2018-200
In early January 2018, the Financial Accounting Standards Board issued Proposed ASU 2018-200, Leases (Topic 842): Targeted Improvements, which would amend Topic 842, Leases. Proposed ASU No. 2018-200 offers an optional transition method that allows entities to apply the new requirements by recognizing a cumulative-effect adjustment to the opening balance of retained earnings in the year of adoption rather than the modified retrospective approach as discussed previously. In addition, Proposed ASU 2018-200 provides a practical expedient for lessors regarding the separation of the lease components and non-lease components of a contract, similar to the practical expedient option available to lessees under ASU 2016-02. However, the practical expedient would be limited to circumstances under which the timing and pattern of revenue recognition are the same for both the non-lease components and the related lease components, and the combined single lease component would be properly classified as an operating lease. The effective date of Proposed ASU 2018-200 would be consistent with the effective date of ASU 2016-02.
Where does this leave you?
While you may have a bit of homework to do now, understanding your entity’s lease contracts and how to account for them prior to the effective date of ASU No. 2016-02 gets you ahead of the game. So let’s get ready to play ball!