What Accounting Staff Need to Know About the New Lease Standard

The new lease accounting standard, Accounting Standards Codification (ASC) 842, is out in full force and there are numerous rules, adjustments and transitions accounting departments need to be made aware of—stat.

To help accounting staff navigate the sweeping changes, we'll dive into the nitty gritty details surrounding ASC 842, including who’ll be impacted, how to determine if a lease exists under the new standard, examples of calculations and journal entries and more.

Who Will Be Impacted by the New Lease Standard and How

As many may know, the new lease standard is effective for all businesses and nonprofits with GAAP financial statements for the 2022 calendar year and fiscal years beginning after December 15, 2021. But who exactly will be most affected by this sweeping change?

Lessees can expect the most change as they're now required to record a right-of-use (ROU) asset and a lease liability on the balance sheet for operating leases. The only exemption to this change is for short-term leases with a term of 12 months or less.

Though lessees are facing the brunt of the new standard, there are minor changes for lessors. Lessors now need to separate non-lease components like revenue for maintenance services, security services, etc., from rental revenue. Lessors must also account for non-lease components under the ASC 606 revenue standard.

Determining if a Lease Exists Under ASC 842

For a contract to qualify as a lease under ASC 842:

• The customer must have the right to receive substantially all the economic benefits from using an asset
• The customer must have the right to control the asset’s use
• A lease must specify, explicitly or implicitly, an identified asset

If a supplier has the right to substitute the asset throughout the period of use, then the contract does not contain a lease under ASC 842. For instance, if a contract to use a space in a shopping mall for a retail kiosk allows the mall owner to substitute another location within the mall, other than the space initially identified in the contract, the contract does not qualify as an ASC 842 lease.

Initial Measurement of Lease Liability and ROU Assets

If the contract is determined to be a lease under the new accounting rule, then the lessee should calculate the initial measurement of a lease’s liability and an ROU asset and record the related journal entries. For a deeper dive into an example calculation and journal entries, check out our blog, Journal Entries to Account for Operating Leases Under the New Lease Standard.

Examples of Calculations and Journal Entries When Initially Recording Leases Under ASC 842

Operating Lease — Example A

The situation:

• A lessee leases a piece of equipment, and the lease term is five years
• Lease payments are fixed at $75,000 and are due annually at the beginning of each year
• Lessee incurs $5,000 of initial direct cost and receives $3,000 cash lease incentive from the lessor at the commencement date
• The lessee will use their 6% incremental borrowing rate as the discount rate to calculate the lease liability

The initial lease liability is $334,883, which is the present value (PV) of the $75,000 annual payments over five years, discounted at 6%. The ROU asset is $336,883 ($334,883 lease liability less the $3,000 cash incentive + $5,000 initial direct costs).

Initial journal entry:

         Debit ROU                          $336,883

               Credit lease liability   <$334,883>

               Credit cash                 <$2,000>*

               *$5,000 cash paid for direct costs less $3,000 cash received for incentive

Operating Lease — Example B

The situation:

• Lessee leases a piece of equipment, and the lease term is three years
• Lease payments are $100,000 for Year 1, $105,000 for Year 2, $110,000 for Year 3 and are due annually at the end of each year
• The lessee will use its 5% incremental borrowing rate as the discount rate to calculate the lease liability

The initial lease liability is $285,498, which is the present value of the annual payments over three years, discounted at 5%. The ROU asset is $285,498, which is the same as the lease liability since there were no incentives received, direct costs paid, etc. for this lease.

Initial journal entry:

         Debit ROU                          $285,498

               Credit lease liability   <$285,498>

The subsequent entries in Year 1 will be:

   Debit lease expense   $105,000

   Debit lease liability    $85,725 ($100,000 lease payment less $14,275 interest component)

               Credit ROU                 <$90,725>

               Credit cash                 <$100,000> (lease payment made in Year 1)

Operating Lease Calculations — Example B

For operating leases, a single lease expense is recognized on a straight-line basis over the lease term— $315,000/3 = $105,000. Therefore, the lessee should recognize $105,000 in operating lease expense each year of the three-year lease term.

Existing Lease — Example C

If the lease in Example B had been in existence a year before the transition to ASC 842, then the initial lease liability at the date of transition would be $199,773 rather than $285,498. It would’ve been calculated based on the PV of the remaining future lease payments at the date of transition.

Initial journal entry to record lease at the date of transition (one year after commencement of lease):

               Debit ROU                   $199,773

               Credit lease liability   <$199,773>

Finance Lease — Example D

If the lease in Example B had been a finance lease instead of an operating lease, the following calculations and journal entries would apply:

Initial journal entry to record lease:

         Debit ROU  $285,498

               Credit lease liability   <$285,498>

The subsequent entries in Year 1 will be:

       Debit interest expense         $14,275

               Credit lease liability                         <$14,275>

       Debit amortization expense  $95,166

               Credit ROU Asset                             <$95,166>

       Debit lease liability                  $100,000

               Credit cash                                     <$100,000> (lease payment made in Year 1)

Transition Methods

There are two methods by which an entity may transition to ASC 842:

• Modified Retrospective Method: An entity applies the transition guidance in ASC 842 as of the beginning of the earliest period presented in the financial statements in which it adopts ASC 842. With this method, a cumulative-effect adjustment is recorded to retained earnings as of the beginning of the earliest period presented.

• Current-Period Adjustment Method: An entity applies ASC 842 as of the beginning of the period in which it adopts the new standard. With this method, a cumulative-effect adjustment is recorded to retained earnings as of the beginning of the period in which ASC 842 is adopted.

Transition Disclosures

For financial statements under ASC 842, entities must provide the disclosures required for a change in accounting principle per ASC 250. The one exception is that an entity is not required to disclose the effect of the change on each financial statement line item presented for the current period or for prior periods that are retrospectively adjusted.

For example, an entity adopting the new standard on January 1, 2022, would not be required to disclose the potential results from 2022 under legacy GAAP or the incremental impact of applying ASC 842 to the prior comparative periods if the entity is using the modified retrospective method. An entity using the current-period adjustment method for transition should disclose the cumulative effect of the change in retained earnings as of the beginning of the period of adoption instead of the beginning of the earliest period presented as required by ASC 250-10-50-1(b)(3).

Disclosures

If your lease does in fact fall under the new lease standard, the following disclosures will need to be included on your organization’s financial statements:

• Lease costs
• Other information (e.g., cash paid to determine the lease liability balance)
• Weighted averages
  • Only comes into play if you have more than one lease
• Maturity analysis

Practical Expedients

An entity may elect the following practical expedients when applied to leases that commenced before ASC 842’s effective date. These practical expedients must be elected as a package and applied consistently by an entity to all of its leases (including those for which the entity is a lessee or lessor).

• An entity need not reassess whether any expired or existing contracts are/or contain leases
• An entity need not reassess the lease classification for any expired or existing leases
• An entity need not reassess initial direct costs for any existing leases

Recording a Tenant Improvement (TI) Allowance for Leasehold Improvements

Under ASC 842, if a TI allowance is paid to the tenant, the tenant’s ROU asset is reduced, but adds a leasehold improvement asset. For instance, if the tenant received a $50,000 TI allowance from the landlord, the tenant would debit leasehold improvements for $50,000 and credit ROU asset for $50,000.

Need Help?

If you have any questions regarding the new lease standard or how to implement it within your organization, contact us here or call 800.899.4623 with questions.