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ASC 842: Accounting for operating leases at transition

Jan 07, 2022

Editor’s note: This is the third article in a three-part series on ASC 842

With ASC 842 on the horizon, many entities are evaluating the impact of the new standard to their financial information and presentation.

ASC 842 contains many nuances, and even minor changes in the fact pattern, expedients or policies elected, or other factors can change the accounting impact, both on day 1 and subsequent accounting. Additionally, the accounting for finance leases, while similar in some respects, is not identical to the accounting for operating leases.

One of the biggest impacts for lessees is the treatment of operating leases under the new standard (ASC 842) compared to the old (ASC 840). , and the impact of the standard on a simple operating lease, providing calculations outlining the initial day one impact as well as the ongoing impact for day two and beyond. 

Example lease fact pattern

ABC Company is a private company with a calendar year-end. ABC Company has a single lease for an office building, which has historically been accounted for as an operating lease. As a result, the company has disclosed the future minimum lease payments in its footnotes to the financial statements but has never presented any asset or liability on its balance sheet related to the lease.

For purposes of this example, assume ABC Company has made the following elections:

  • Elected the modified retrospective (cumulative catch-up) approach to adoption, and early adopted on Jan. 1, 2021.
  • Elected the “package of three” expedients allowing it to not reassess expired or existing contracts for embedded leases, not reassess lease classification, and not reassess initial direct costs. This all assumes that the accounting and classification was accurate and appropriate under ASC 840.
  • Elected to not separate lease and nonlease components for all underlying asset classes.
  • Elected to use the risk-free rate as the discount rate when the rate implicit in the lease is not readily determinable.
  • Did not elect the hindsight expedient and does not have land easements.
  • Will elect the short-term lease exemption, when applicable.

ABC Company’s lease commenced Jan. 1, 2018, and has an original term of five years. The agreement has a renewal option for one additional two-year period. Management has determined as of Jan. 1, 2021, (the adoption date) that ABC Company is reasonably certain it will exercise the renewal option.

Under the terms of the agreement, ABC Company makes monthly payments of $5,000. This payment covers both the rent payment of $4,500 per month and the fixed monthly common area maintenance (CAM) fees of $500.

One of the first steps as part of the transition process is to determine the remaining lease term. The lease term is the non-cancellable period of the lease, which includes periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option (ASC 842-10-30-1).

Because the lease commenced Jan. 1, 2018, 36 months of the original 60-month term has passed. However, because ABC Company is reasonably certain to exercise the renewal option, the 24-month renewal period must also be added to the remaining 24 months from the original term. Therefore, the remaining term of ABC Company’s operating lease for the office building is 48 months.

Initial calculation: Day 1

Once the lease term is known, the initial calculation can be performed.

The lease liability is calculated first and is based on the present value of future lease payments, using the applicable discount rate. Based on the remaining term on the adoption date, ABC Company should calculate the lease liability as the present value of 48 monthly payments of $5,000.

Importantly, the whole $5,000 monthly payment is included in the calculation because of ABC Company’s election not to separate lease and nonlease components. $4,500 is a lease component relating directly to the use of the underlying asset while the $500 related to CAM fees is nonlease component as it relates to other goods or services. However, ABC Company elected not to separate the lease and nonlease components and instead will account for both as a single lease component.

To calculate the present value, ABC Company must determine the appropriate discount rate.

The rate implicit in the lease is not readily determinable. However, instead of applying its incremental borrowing rate, ABC Company has elected to use the risk-free rate as of the application date over a similar period of time. The risk-free rate used was the US Treasury yield curve rate associated with a 48-month term. While the US Treasury publishes a 36-month rate (.16%) and a 60-month rate (.36%), it does not have a 48-month rate. Therefore, ABC Company uses a weighted average of the available rates to determine an appropriate 48-month rate of .26%.

The lease liability is then calculated based on the present value of 48 payments of $5,000 made monthly at a discount rate of .26%. One simple method of calculating the present value of future payments is through an Excel formula (this obviously becomes difficult if there are escalating payments, free rent periods, etc.):

=PV(rate, nper, pmt, [fv], [type])

rate is the annual rate of .26% divided by 12 to determine the monthly rate applied in the formula.

nper is the number of periods or payments

pmt is the amount of the payment (assuming they are all equal)

[fv] is the future value which is not applicable in this instance and can be left blank

[type] is the type of payment. “1” is a payment in advance while “0” is a payment in arrears.

=PV((.26%/12),48,-5000,,1)

The result of this calculation is a lease liability as of Jan. 1, 2021, of $238,782.31.

After the lease liability is calculated, the right-of-use asset is calculated. The right-of-use asset uses the lease liability as a starting point and then adds any unamortized initial direct costs and any prepaid lease balances and then subtracts any lease incentives received. This example does not have any initial direct costs, prepaid rent or lease incentives. Therefore, the initial right-of-use asset has no adjustments and is equal to the lease liability.

Upon adoption of the new standard, the initial impact and journal entry would be as follows:

Right-of-use asset – operating

$238,782.31

Lease liability – operating

$238,782.31

Subsequent accounting: Day 2

Two transactions occur each month that will affect lease accounting. First, ABC Company makes rent payments on the first day of each month. Second, at the end of each month, ABC Company should amortize one month’s portion of the right-of-use asset. These two transactions will be recorded as follows for January 2021, the first month after adoption of the new standard.

On January 1, 2021, ABC Company cuts a check to pay January’s rent. This transaction affects only cash and the lease liability:

Lease liability – operating

$5,000.00

Cash

$5,000.00

The second portion of the monthly transactions is a little more complex than the rent payment portion.

At the end of each month, an entry is made to reflect

  1. Amortization of the right-of-use asset
  2. The accretion of “interest” on the lease liability

Unlike a finance lease (historically a capital lease), entities won’t incur interest expense on the income statement – so this isn’t really “interest.” Instead, this is an adjustment to reflect the new present value of the remaining payments. A month’s time has passed, so the old present value calculation needs to be updated to reflect the passage of time.

On January 1, 2021, the lease liability brought onto the balance sheet was $238,782.31. However, also on January 1, 2021, a rent payment was made that reduced the lease liability by $5,000. Because this payment was made at the beginning of the period in the first month, the present value of the payment was also $5,000. Therefore, the “interest” being calculated is based on the remaining lease liability balance during January, which is $233,782.31 (the original lease liability less the first $5,000 payment).

The accretion of “interest” can then be calculated. The monthly interest rate (.26% divided by 12) is multiplied by the lease liability balance to determine January’s interest.

“Interest” = (.26% ÷ 12) x $233,782.31 = $50.65

The right-of-use asset is also adjusted. The adjustment to the right-of-use asset is the difference between the straight-line payment amount and the “interest” portion of the payment accreted to the lease liability. In this example, the actual payments also represent the straight-line payment amount.

Adjustment to right-of-use asset = $5,000 - $50.65 = $4,949.35

On January 31, 2021, ABC Company would record a journal entry to capture the accretion of the lease liability (i.e., remeasure the present value of future payments), amortize the right-of-use asset, and record lease expense.

Lease expense

$5,000.00

 

          Right-of-use asset – operating

 

$ 4,949.35

         Lease liability – operating

 

$50.65

This same set of journal entries would occur monthly. First, an entry is recorded for the cash payment made. This entry reduces the lease liability directly with the offsetting credit to cash. Second, at the end of the period, the “interest” is calculated and accreted back to the lease liability to adjust the present value of the remaining payments and the right-of-use asset is adjusted to represent the use of the asset. The offsetting debit for this entry will be recorded as lease expense.

How Wipfli can help

If you have questions about implementation of the new standard, its impact on your organization, potential software solutions to assist in tracking and maintaining your organization’s lease information, please contact us.

Read more in our series

Author(s)

Preston Tomlinson, CPA
Manager
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