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Balance Sheet Changes for ASC 842 [2021]

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ASC 842 Lease Accounting Balance Sheet Examples

The Federal Accounting and Standards Board (FASB) created the new lease accounting standard (ASC 842) , which has raised questions about how balance sheets are affected. We’ve answered your top 10 questions about how ASC 842 will impact your balance sheet.

What is the purpose of the FASB lease accounting changes?

FASB ASC 842 increases disclosure and visibility into the leasing obligations of both public and private organizations.

Prior to ASC 842, most leases were not included on the balance sheet. The new standard requires companies to report right-of-use (ROU) assets and liabilities for almost all leases. The changes make it easier for users of financial statements to see a company’s exposure to risk and the true financial position of the organization, and to make comparisons between organizations.

Another important purpose of ASC 842 is to more closely align with the new international lease accounting standard (IFRS 16) , especially around the definition of a lease.

Are operating leases on the balance sheet?

Under the ASC 840 standard, only accounting for capital leases were recorded on the balance sheet. Operating leases were off the balance sheet, and the impact was generally limited to deferred rent or prepaid rent. The only insight you had for future obligations was limited to the maturity analysis in the disclosure report.

Under ASC 842, every lease (with the exception of short-term leases as defined below) must be represented on the balance with a liability and a ROU asset.

Additionally, disclosure reports must include more qualitative and quantitative disclosures under 842, such as weighted average discount rate, weighted average remaining lease term, cash paid for amounts included in lease liabilities, and a more descriptive maturity analysis (which must be tied back to the balance sheet).

How are ASC 842 short term leases and low value leases defined?

Under ASC 842, a short-term lease is defined as a lease that has a term of 12 months or less at commencement, and the lease does not have a renewal option that the lessee is reasonably certain to exercise.

Short-term leases do not need to be included on your balance sheet under ASC 842. However, you may recognize short-term lease payments on a straight-line basis over the lease term (similar to the way operating leases are recognized under ASC 840).

This practical expedient for short-term leases must be elected at the asset class level. That means you can’t pick and choose leases to define as short term; you’ll need to define the entire asset class as part of your practical expedient.

It’s also important to note that FASB has not defined a materiality threshold (where low value leases under a certain threshold may be excluded). IFRS (the international standard) has defined a low value lease threshold under which leases don’t have to be capitalized on the balance sheet, but FASB has not included this practical expedient to date. We recommend discussing the issue with your auditors to determine if they will allow you to use a materiality threshold.

How are capital leases reported on the balance sheet under ASC 842?

A finance lease (previously called a capital lease in ASC 840)  is a lease that’s effectively a purchase arrangement.

ASC 840 capital leases and ASC 842 finance leases are substantially the same. Both are capitalized on the balance sheet, and the method for doing so is similar under both standards.

ASC 842 Lease Accounting Example

Here’s an example of a balance sheet for 840 and a balance sheet for 842. Both represent the same capital/finance lease data.

As you can see, only the terminology has changed. Total assets and liabilities remained the same for the reporting period. If we were to look at the income statement, the amortization and interest expense are calculated the same way in ASC 842 as they were in ASC 840. So there would be no impact to the P&L in this example.

When transitioning your existing leases to the new standard, you will need to reclassify Capital Lease Asset and Capital Lease Liability (840) to ROU Asset and Lease Liability (842). Any prepaid rents, lease incentives, and initial direct costs are rolled up into the ROU asset. (Refer to question 8 for more details about calculating the ROU asset).

How are operating leases reported on the balance sheet under ASC 842

In an operating lease , the lessee obtains control over the use of the underlying asset without ownership. (Refer to question 9 for information about how to classify a lease as either an operating lease or a finance lease for ASC 842 reporting.)

Under ASC 840, operating leases were unrecorded liabilities. Balance sheet impact for operating leases was limited to prepaid or deferred rent.

Accounting for operating leases represents the biggest change in ASC 842, and it will materially impact your balance sheet going forward.

All operating leases (except for short-term leases) are now capitalized on the balance sheet for FASB 842 the same way we previously would record capital leases under ASC 840, and now finance leases under ASC 842. They are recorded on the balance sheet as a ROU asset and lease liability.

Operating lease expense is still straight-lined over the lease term:

• Operating lease liability is accounted for the same way as a finance lease, using an amortized cost basis.
• Amortization of the ROU asset is calculated as the difference between straight line rent and interest expense for the period.

These two expenses added together give you the total lease expense to book on your P&L.

Operating Leases on the Balance Sheet Example

Here’s an example of a balance sheet for 840 and a balance sheet for 842. Both represent the same operating lease data.

In this example, we have included only a single operating lease. It’s a real estate lease with an initial lease term of January 1, 2018 to December 31, 2025. The rent starts out at $27,000 per month, and increases 2% each year until it gets to the final amount of $31,014.51. For the sake of simplicity, we do not have any prepaid rents, initial direct costs, or lease incentives on this lease.

As you can see, under ASC 840, we have a very small deferred rent balance of $23,610 as of 12/31/18. Our Total Assets are only about $9.8 million and our Total Liabilities are only $5.5 million. Realistically, we have a future cash obligation on this lease of almost $2.5 million dollars, but the only way we would see that under 840 is if we dug into the disclosure report and looked at the maturity analysis. And remember, even the maturity analysis is not a fair representation of our actual liability, because of the time value of money.

Looking at the same example under ASC 842 (using a 5% discount rate), you can see a very different impact on the balance sheet.

To provide an apples-to-apples comparison with 840, we are capitalizing this lease on 1/1/18 and not transitioning. Our net present value of payments, which is the starting point for your lease liability, is almost $2.3 million.

As of 12/31/18, you can see that we have a total right of use asset of $2,046,000, and a total lease liability of $2,069,000 (including both short term and long term lease liability). Our Total Assets for the year went from about $9.8 million to $11.8 million. Our Total Liabilities went from $5.5 million to about $7.6 million.

For this example, there’s no change to the P&L. Our straight line rent expense under ASC 840 is $347,610 for 2018. Under ASC 842, the total lease expense is the same, but $239,000 is related to amortization, and $108,000 is related to interest expense. For 2018, we’ve made $324,000 in payments, but only reduced the liability balance by $216,000.

Keep in mind that the impact on this balance sheet represents only a single 5-year real estate lease. When you extrapolate this out to an entire property portfolio, and also capitalize any equipment leases you may have, the balance sheet impact will be much, much larger.

How has lease classification changed under ASC 842?

Upon adoption of ASC 842, almost all leases will be capitalized on the balance sheet. However, you will still need to classify them as either finance leases (previously called capital leases) or as operating leases using the lease classification test so that you can apply the correct accounting treatment.

Lease Classification Test

The lease classification test questions determine whether the leased asset is essentially owned as well as controlled by the lessee. If so, the lease must be classified as a finance lease. If the lessor retains ownership, the lease must be classified as an operating lease. So if the lease is non-cancelable and you answer YES to one or more of the lease classification test questions, then the lease is classified as a finance lease.

These four lease classification test questions remain the same as ASC 840:

Transfer of title test: By the end of the lease term, will ownership of the asset transfer from the lessor to the lessee?

Bargain purchase option test: Is there a purchase option in the lease that the lessee is reasonably certain to exercise?

Lease term test: Does the lease term encompass the major part of the remaining economic life of the underlying asset?

Present value test:   Is the present value of lease payments plus RVG (residual value guaranteed by the lessor) greater than or equal to substantially all of the fair market value of the asset?

A fifth test question has been added in ASC 842:

Alternative use test: Is the asset so specialized that it is only useful to the lessee? This new test question means that after the asset is returned to the lessor, will it have no value to anyone else without a major overhaul by the lessor?

You may have noticed that the “bright lines” for lease classification tests have been removed in ASC 842. Previously they indicated what percentage constitutes a “major part” of economic life (75%) or “substantially all” of the fair market value (90%). These are now considered guidelines under the new standard and you can elect what percentage you choose to use.

In the past, it was easy to manipulate this number and classify more leases as operating leases (which did not need to be capitalized). Under ASC 842, all operating leases are recorded on the balance sheet anyway, so there’s no reason to do this.

How is lease liability calculated?

Lease liability is calculated as the Present Value of minimum future lease payments. You will need to make assumptions about the probable amounts owed under residual value guarantee, and also whether you are reasonably certain to exercise renewal options, termination options, and purchase options, because exercising these options impacts your minimum future lease payments.

The discount rate to use for the calculation is either the rate implicit in the lease (if known), or your organization’s incremental borrowing rate.

It’s important to remember that the assumptions you make at the inception of the lease (about whether or not you will exercise options) can and often do change over time. When those changes happen during the term of a lease, you will need to remeasure both your lease liability and your ROU asset. Remeasurements may also be needed due to abandonments, asset impairments and other causes.

How to calculate ROU?

The ROU asset is calculated as the lease liability plus or minus certain adjustments , which include:

+ Initial Direct Costs

+ Prepaid Lease Payments

– Lessor Incentives

– Accrued Rent

– ASC 420 Liability at Transition Date

All of these assets and liabilities that adjust the ROU asset are now reclassed from the balance sheet and included as one number to show the total leased asset.

What is an embedded lease?

Accounting for embedded leases represents one of the trickier aspects of implementing the new ASC 842 standard. Simply put, embedded leases are components within contracts that entail the use of a particular asset, where the user has control over that asset. A lease may exist within a contract even though the contract may not contain the word “lease.”

For example, embedded leases are commonly found in IT service contracts, where a vendor may provide specific equipment (such as on site servers). They are also frequently found in supply contracts, dedicated manufacturing capacity contracts, and advertising agreements (such as use of billboards).

You may have done some embedded leases accounting in the past, and the process has not changed much in ASC 842. However, this is now a significant issue because embedded leases have a much bigger impact on your income statement under the new rules.

Under ASC 840, operating leases were off balance sheet, so any embedded leases had an immaterial impact to the income statement since the expense was probably being straight lined anyway.

ASC 842 requires ALL leases to be capitalized on the balance sheet, including all embedded leases. That means you will need to examine your contracts to find any embedded leases within them, and you will need to separate the lease components (for use of assets within a contract) from non-lease components (payments for the service) within these contracts.

This is a complex and time-consuming task, so be sure to allocate the necessary time and resources to get it done. It also involves making judgments, so it’s imperative that people doing this work are experienced with leases and understand the standard. Also, you must document your policies and procedures to support your decisions and to provide justification for future audits.

How to identify an embedded lease

As you review the content of your existing contracts, ask these questions to decide (ideally with the guidance of your advisory partners) if they contain embedded leases :

• Does the agreement entail the use of one or more specific assets?

If no assets are specified, then no lease can exist within the contract. However, if an asset is explicitly or implicitly identified within an agreement, then a lease may exist.

• “Explicit” means the asset is identified on the contract, such as by a serial number or VIN number.
• “Implicit” means use of a specific asset is implied even if not explicit, such as when the supplier can’t fulfill the contract with any other asset for legal or economic reasons.

For example, power purchase agreements may include the use of a specified plant. Oil and gas drilling contracts may specify the use of equipment and pipelines.

• Is the asset physically distinct?

For a lease to exist, a specified asset must be a physically distinct object. Something intangible, such as exploration rights, cannot be considered an asset. A biological entity also cannot be considered an asset under 842.

• Does the supplier have substantive substitute rights for the asset?

If your agreement does specify the use of an asset, can the supplier easily substitute a different asset, and would the supplier benefit from doing so?

• If the supplier can substitute the asset and benefit economically by exercising that right, a lease may not exist in the contract.

Here’s an example : If a supplier uses trucks to ship materials and has the ability to substitute different trucks (with a smaller or larger capacity as needed), then there is no lease.

• If the supplier can’t substitute the asset and would not benefit from doing so, then the use of that asset may be considered a lease.

For example: A managed services contract might include office copiers. It’s not likely that the supplier can easily swap out one machine for another. And it’s also not likely that the supplier would benefit financially from doing that even if they could. In that case, the use of the office copier would constitute a lease.

• Does the customer obtain the economic benefit from using the asset?

If you as the customer get substantially all of the economic benefit from the use of the asset, then your use of that asset may be considered a lease.

Common practice is to interpret “substantially all” to mean greater than or equal to 90% of the economic benefits of the asset.

• Can the customer direct use of the asset? If you have physical control and decision making authority over when and how the asset is used throughout the period of the lease, then a lease may be present.

Read More Content About ASC 842

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Right-of-Use Asset (ROU Asset) and Lease Liability for ASC 842, IFRS 16, and GASB 87 Explained with an Example

by Jaron Moss, Technical Accounting Consultant | Jun 3, 2023

1. What is a right-of-use asset?

2. What is a lease liability?

3. Right-of-use asset under ASC 842

How to calculate the right-of-use asset under ASC 842

Right-of-use asset accounting example.

4. Right-of-use asset under IFRS 16

How to calculate the right-of-use asset under IFRS 16

5. Lease asset under GASB 87

How to calculate the lease asset under GASB 87

6. Right-of-use asset amortization

7. Lease liability calculation under ASC 842, IFRS 16, & GASB 87

Private company practical expedient offered under ASC 842

8. Right-of-use assets and lease liabilities on the balance sheet: Placement and impact

What is a right-of-use asset?

In lease accounting , a right-of-use asset, or ROU asset, is an asset that represents a lessee ’s privilege to use a leased item over the duration of an agreed-upon lease term . In other words, the lessee is granted the authority to obtain the economic benefit from the usage of an asset owned by another entity. Under GASB 87 , this asset is referred to as the “lease asset.”

What is a lease liability?

A lease liability, as appropriately named under three major standards ( ASC 842 , IFRS 16 , and GASB 87), is the financial obligation to make the payments arising from a lease, measured on a discounted basis.

Right-of-use asset under ASC 842

ASC 842 differs from GASB 87 and IFRS 16 as a result of retaining its dual-model approach to presenting lease assets and lease liabilities on the balance sheet and income statement. In other words, ASC 842 continues to distinguish between operating leases and finance leases with each lease classification requiring a capitalized ROU asset.

However, accounting for finance leases, previously referred to as capital leases , under ASC 842 is largely unchanged compared to ASC 840 . Under the old standard, lessees were required to record an asset and liability for capital leases. The same is true under ASC 842.

Under ASC 842, initial operating and finance lease ROU assets are calculated using the same method. Start with the initial amount of the lease liability, computed by discounting the remaining lease payments, and adjust for any lease payments made to the lessor at or before commencement, less any incentives received, and any initial direct costs incurred by the lessee. Expressed as a formula shown below:

Initial lease liability

+ Outstanding balance of prepaid rent

– Cumulative remaining deferred rent

+ Initial direct costs

– Lease incentives paid at or before the commencement of the lease

It is important to note that for basic leases, the ROU asset and lease liability will be equal upon lease commencement . For example, if a company has a lease without initial direct costs, prepaid/deferred rent, or a tenant improvement allowance (or some other lease incentive), then the ROU asset and the lease liability will be equal on the lease commencement date.

Next, we will walk through a brief example of how to calculate the ROU asset for an operating lease under ASC 842 assuming the facts below.

Entity Information:

Private Company

Fiscal Year End: December 31

Transition Date: January 1, 2022

Borrowing Rate: 5%

Lease Details:

Lease Term : 5 years

Lease Commencement: January 1, 2021

Lease End Date: December 31, 2025

Lease Payments: $2,500 due on the first of each month, starting January 1, 2021

Rent Escalation: Increases of 3% each year starting January 1, 2022.

Initial Direct Cost: $10,000 capitalized on lease commencement

Incentive: $20,000 cash received at lease commencement

First Step: Calculate the lease liability

For this example, take the contractual payments from January 1, 2022, the entity’s transition date, through December 31, 2025, and apply the established borrowing rate of 5% to calculate the lease liability.

Using the free present value calculator from our website returns a present value of approximately $117,218 (rounded to the nearest dollar).

Second Step: Calculate the ROU asset

Since this lease commenced prior to the entity’s transition to ASC 842, to calculate the value of the ROU asset we will first need to determine the incentive, initial direct cost, and any prepaid/deferred rent balances as of December 31, 2021.

Prior to transitioning to ASC 842 the proper treatment of incentives and initial direct costs was to capitalize them as of lease commencement and then depreciate them on a straight-line basis over the lease term. In this example, we capitalized the initial direct costs and incentive on the first day of the lease (January 1, 2021). Below are portions of the amortization schedules for each of these items before the entity’s effective date of ASC 842.

Under ASC 840, operating leases were accounted for by straight-lining the rent expense over the lease term, creating deferred or prepaid rent. Deferred rent was a result of rent payments increasing over time while rent expense stayed constant due to the straight-line approach.

Below is a portion of the deferred rent schedule for the lease in this example.

With the appropriate incentive, initial direct cost, and deferred rent balances we are able to calculate the initial ROU asset on January 1, 2022.

Third Step: Create the amortization schedule

Once the lease liability and ROU asset have been calculated, calculate the rent expense and create the amortization schedule to be used to create the periodic journal entries.

The total lease expense for an operating lease under ASC 842 is the sum of the remaining payments as of the transition date adjusted for any deferred/prepaid, incentive, or initial direct cost balances, divided by the remaining term of the lease.

In this example, the total remaining cash payments equal $129,276, as shown in the payment schedule below.

The total remaining cash payments are then adjusted for the remaining balances of deferred rent, incentives, and initial direct costs as of December 31, 2021, included in the ROU asset calculation, as shown below.

The total net payment amount of $119,421 is divided by the remaining lease term of 48 months (January 1, 2022 – December 31, 2025) to calculate a lease expense of $2,488. The initial lease liability and ROU asset as of January 1, 2022, and the calculated lease expense are used to create the amortization table, a portion of which is shown below.

Download the Ultimate Lease Accounting Guide for more examples

Our Ultimate Lease Accounting Guide includes 44 pages of examples, journal entries, disclosures, and more step-by-step guidance on operating leases and finance leases under ASC 842.

Right-of-use asset under IFRS 16

A classification distinction between operating and finance leases does not exist under IFRS 16. Rather, a single model approach is applied whereby all lessee leases post-adoption are reported as finance leases. These leases are capitalized and presented on the balance sheet as both assets and liabilities, unless subject to any of the exemptions prescribed by the standard. IFRS 16 also refers to the lease asset as an ROU asset.

IFRS 16 directs lessees to calculate the ROU asset as the following:

The initial amount of the lease liability

+ Payments made at or before the commencement of the lease

– Lease incentives

+ Estimated costs for restoration or removal/disposal per IAS 37 Provisions, Contingent Liabilities, and Contingent Assets

Lease asset under GASB 87

Similar to IFRS 16, GASB 87 uses a single-model approach and classifies all leases as finance leases. GASB 87 also requires the lessee to recognize an intangible right-to-use lease asset, referred to as a lease asset, in conjunction with a lease liability. However, in order to do so, the reporting entity must have the right to control and obtain economic benefit from the present service capacity of the underlying asset.

In addition, the following types of leases are exempt from recognizing a right-to-use asset and lease liability under GASB 87:

• Leases not meeting the definition of an exchange-like transaction
• Leases containing a provision for a title transfer
• Leases with a lease term of 12 months or less, including renewal options regardless of intention to exercise

When capturing the activity within the governmental fund , a conversion entry will be necessary at year-end to convert from the modified accrual accounting basis to the full accrual basis required for government-wide financials.

In order to compute the initial leased asset amount a lessee should take the total of:

The initial lease liability

+ Outstanding prepaid rent amounts

– Any cumulative remaining deferred rent

– Unamortized incentive balances received at or before the commencement of the lease

+ Initial direct costs incurred to place the asset into service

Right-of-use asset amortization

ASC 842 requires the right-of-use asset for operating leases to be amortized differently than for finance leases. The right-of-use asset for an operating lease is amortized in a systematic and rational basis by subtracting the liability lease expense from the total lease expense. Finance lease assets are amortized on a straight-line basis.

ASC 842 also requires operating lease ROU assets to be amortized from the lease commencement date (the date the lessee obtains possession of the underlying asset) to the end of the lease’s term. In some cases, it may be from the commencement date to the end of the useful life of the asset. The same holds true for finance leases under ASC 842, IFRS 16, and GASB 87.

Lease liability calculation under ASC 842, IFRS 16, & GASB 87

A lease liability is the financial obligation for the payments required by a lease, discounted to present value. Under ASC 842, IFRS 16, and GASB 87, the finance lease liability is calculated as the present value of the lease payments remaining over the lease term. The preferred discount rate to use is the discount rate implicit in the lease under each of the three major lease standards. However, each standard also allows for the use of an incremental borrowing rate defined by the standard in specific circumstances when the implicit interest rate can not be determined.

IFRS 16 also requires lessees to remeasure lease liabilities when future payments change, potentially affecting balances when the lease payments are tied to an index. This is not the case, however, under GASB 87 and ASC 842. For more detail on this, read our blog, “ IFRS 16 vs. ASC 842 (US GAAP) Lease Accounting: What Are the Differences? “

Under ASC 842, initial operating lease liabilities and finance lease liabilities are calculated using the exact same method.

ASC 842 offers an additional interest rate option to private companies and nonprofits. Non-public entities have the option to elect a risk-free rate as the discount rate for lease liability calculations. As a result of the FASB’s post-implementation review process, private entities can apply the risk-free rate by class of underlying asset rather than having to apply it to the entire lease portfolio.

Right-of-use assets and lease liabilities on the balance sheet: Placement and impact

An operating lease is a contract providing a lessee the right to use an asset without the benefits of ownership. Despite companies’ obligations to make the lease payments associated with their operating leases, ASC 840 and IAS 17 did not require a lease asset or a lease liability to be recorded on the balance sheet, nor did GASB require recording an asset or liability on the statement of the net position under GASB 13 or GASB 62 .

ASC 842, IFRS 16, GASB 87, however, now require the capitalization of almost all leases – a major shift in the way lessees account for their operating leases. Aside from the ability to take advantage of a policy election allowing a lessee to account for leases with terms shorter than 12 months similar to an operating lease under the legacy standards, and a few other exemptions seen under GASB 87, all leases must be recognized on the balance sheet with a lease liability and ROU asset, calculated at initial recognition as discussed at the beginning of the article.

Operating lease classification has also changed under all three standards, but in different ways. Under IFRS 16 and GASB 87, all leases are classified as finance leases, eliminating the “operating lease” classification. This isn’t the case for ASC 842, though, which makes the following changes to the lease classification criteria :

• A bargain purchase option criteria no longer exists. If the lease contains an option to purchase the underlying asset the lessee is reasonably certain to exercise, the lease qualifies as a finance lease.
• The “75% of lease term” and “90% of FMV” rules are no longer definitive. However, the FASB has suggested companies should continue to use these thresholds in their analyses, unless a more appropriate threshold exists, based on the company’s facts and circumstances. Entities need to develop an overall policy with regard to these thresholds to use consistently.
• A new fifth test has been added – entities must now consider whether or not the asset is specialized in nature and has any future value to the lessor.

This is primarily a result of the FASB moving away from “rules” based accounting to “principle” based accounting.

Regardless of which lease accounting standard is adopted, each standard will result in the recognition of a right-to-use asset and lease liability on the balance sheet upon transition. Reporting entities must have a firm grasp of the financial statement presentation and the methods of computing the ROU asset and corresponding lease liabilities, as each guidance has its own nuanced definition of what is deemed a reportable lease and what variables factor into the calculations.

This comprehensive guide on understanding the ROU asset as it relates to both finance and operating leases should help in future calculations. If it’s unclear what type of lease the organization has, LeaseQuery offers a number of free lease accounting tools to help. To learn more,  schedule a LeaseQuery demo today.

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The new lease accounting standard recently became effective for private companies. Here are answers to many questions being asked about ROU assets. 

As of Jan. 1, 2022, the Financial Accounting Standards Board (FASB) lease accounting standard, Accounting Standards Codification (ASC) 842, “Leases,” became effective for many private companies, requiring lessees to recognize most leases on their balance sheets. But many organizations still have questions about how to get up to speed on preparation and compliance.

The most significant change under this new guidance is that lessees now need to recognize a lease liability and corresponding right-of-use (ROU) asset for those leases previously classified as operating leases. Consequently, all leases, whether finance or operating, now will be on balance sheet unless they are subject to the short-term lease accounting policy election. A lessor’s accounting for direct-finance, sales-type, and operating leases under the new standard is similar to existing GAAP.

For lessees, most capital leases under existing GAAP will be accounted for as finance leases under the new standard. Similarly, most operating leases under existing GAAP will remain operating.

Under the new standard, a lessee evaluates whether a lease is classified as finance or operating at the commencement of a new lease and upon a change in the lease term or change in the lessee’s option to purchase the asset. The criteria for classifying a lease is, in most cases, generally consistent with existing GAAP.

The differences in lease classification are outlined in the following table: 

Frequently asked questions and answers about the ROU asset 

Q: What does an ROU asset mean in accounting?  A: While most of the focus of ASC 842 revolves around the fact that lessees are reporting a lease liability representing the future lease payments, many stakeholders have asked, “What is an ROU asset, and how is it accounted for?” The ROU asset represents the lessee’s right to control the use of the underlying lease asset for a period of time. Under U.S. GAAP, the ROU asset is considered a long-lived asset that is accounted for following Topic 842’s initial and subsequent measurement guidance. Lessees also must evaluate the ROU asset for impairment in accordance with Topic 360, “Property, Plant, and Equipment,” which broadly applies to other long-lived assets.  

Q: How is the ROU asset initially measured?  A: The ROU asset’s initial measurement is based on the initial measurement of the lease liability, plus any lease payments made to the lessor at or before lease commencement, less any lease incentives received, plus any initial direct costs incurred by the lessee. 

Q: How is the ROU asset measured upon initial adoption of Topic 842?  A: The answer depends on how the lease is classified and whether the package of transition practical expedients is elected. Most entities are expected to elect to use the package of transition practical expedients, in which case an entity’s classification of its existing leases is not reassessed. Entities that elect to apply the package of transition practical expedients should initially measure the ROU asset as follows:  

The transition adjustment, in most cases, is largely a balance sheet gross-up. Entities with significant balances of lease incentives, deferred rent, and/or obligations under Topic 420, “Exit or Disposal Cost Obligations,” at the transition date should keep in mind that these balances are, in most cases, merely reclassified on the balance sheet in establishing the initial ROU asset. That is, in most cases, the balances are not derecognized or adjusted through a cumulative effect adjustment to equity. 

Q: Can the ROU asset exceed the fair value of the underlying asset?  A: Yes, unlike the old lease guidance for capital leases, Topic 842 does not prohibit this scenario. However, entities in this position should assess the accuracy of their lease measurement assumptions, such as the discount rate, identification of lease and nonlease components (if applicable), and allocation of contract consideration between the lease and nonlease components (if applicable). 

Q: How is the ROU asset subsequently measured?  A: The answer depends on whether the lease is classified as a finance lease or an operating lease, as follows: 

Q: How is the ROU asset of an operating lease subsequently measured after an impairment? A: After an impairment, the ROU asset reverts to being amortized over the remaining lease term on a straight-line basis. 

Q: How are lease incentives subsequently accounted for?  A: As previously described, the subsequent measurement of an operating lease’s ROU asset is largely a “plug” for the difference between the lease’s straight-line lease cost and the change in the lease liability (that is, the accretion of the liability based on the discount rate less lease payments made during the period). Consequently, lease incentives that were recognized upon initial measurement of the ROU asset subsequently are adjusted through the adjustment to the ROU asset. 

Topic 842 is silent regarding how to account for contingently receivable lease incentives that are expected to be received after the lease commencement date (for example, a buildout allowance provided by the lessor after the lessee incurs buildout costs). More than one acceptable approach exists to account for lease incentives that are neither paid nor payable at lease commencement; however, the approach depends on the facts and circumstances of the lease incentive’s terms and conditions. Entities should evaluate the terms and conditions of significant lease incentives and discuss their approach with individuals responsible for accounting policy decisions and governance, as well as with their accounting advisers or independent accountants, as applicable. 

Q: What are some other examples of when the ROU asset might be subsequently adjusted?  A: Besides applying the subsequent measurement guidance previously described and evaluating the asset for potential impairment in accordance with Topic 360, entities need to consider the impact to the ROU asset when the following events or conditions take place: 

• A modification is made that does not grant the lessee an additional ROU asset at a market rate, including a partial termination of the lease. Topic 842 introduces a more robust framework to account for lease modifications than prior GAAP. 
• The lease is fully terminated before the expiration of the lease term. 
• A remeasurement triggering event occurs, as outlined in the following table: 

Q: What are some examples of circumstances that might necessitate an impairment evaluation under Topic 360?  A: Applying the impairment model in Topic 360 can be a complex assessment for lessees. To start, an impairment evaluation under Topic 360 is performed at the asset group level. Determining asset groupings can require considerable judgment. Next, a lessee performs an impairment test only when events or changes in circumstances (that is, triggering events) indicate the carrying amount of the asset or asset group might not be recoverable. If triggering events are present, the lessee performs a two-step impairment test, as follows: 

• Step 1: Recoverability test. Compare the carrying amount of the asset or asset group to the sum of the estimated undiscounted future cash flows attributable to the asset or asset group. If the carrying amount exceeds the undiscounted cash flows, Step 2 of the impairment test must be performed. 
• Step 2: Measuring an impairment. An impairment loss is recognized if the carrying amount of the asset or asset group exceeds its fair value. 

Performing the two-step impairment test can be another complex undertaking requiring management to use considerable judgment in its estimates and assumptions. Here are some examples of when a lessee should consider whether an impairment triggering event has occurred: 

• The lessee has completely abandoned the leased asset by permanently ceasing its use with no right or intent to sublease the asset. 
• The lessee plans to abandon the leased asset, which also might prompt the need to reassess the lease term – and consequently lease classification. 
• The lessee subleases (or decides to sublease) the leased asset. 
• The lessee changes (or plans to change) the fundamental use of the leased asset. 

Q: Will adopting Topic 842 change working capital?  A: By recognizing operating leases on the balance sheet, an entity will add to the balance sheet a lease liability – classified between current and noncurrent, with the corresponding ROU asset classified as a long-term asset. Consequently, holding all other variables equal, working capital will be lower after adopting Topic 842.  

Some companies might have concerns about a perception of additional leverage with ROU assets and operating lease liabilities now on the balance sheet. However, several mitigating factors exist, including these 1 : 

• Topic 842 characterizes operating lease liabilities as operating liabilities instead of debt and therefore typically should not affect most debt covenant calculations. 
• Many credit agreements contain “frozen GAAP” provisions that indicate that changes in GAAP will not constitute a default or will require both parties to negotiate in good faith if technical default occurs as a result of the adoption of new GAAP. 
• Banks with whom the FASB conducted outreach indicated they are unlikely to “call a loan” with a good customer because of a technical default arising solely from the adoption of new GAAP. 
• The extended effective date provides additional time for companies to modify agreements to the extent necessary. 

1 Accounting Standards Update 2016-02, “Leases (Topic 842) Section C – Background Information and Basis for Conclusions,” paragraph BC14, FASB, https://fasb.org/jsp/FASB/Page/SectionPage&cid=1176156316498 

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Home » Resources » FASB Topic 842: Presentation and Disclosure

FASB Topic 842: Presentation and Disclosure

June 13, 2019

Introduction

In February 2016, the Financial Accounting Standards Board (“FASB” or “the Board”) issued its highly-anticipated leasing standard in ASU 2016-02 (“ASC 842” or “the new standard”) for both lessees and lessors. Under its core principle, a lessee will recognize right-of-use (“ROU”) assets and related lease liabilities on the balance sheet for all arrangements with terms longer than 12 months. The pattern of expense recognition in the income statement will depend on a lease’s classification.

During deliberations for the standard, many users indicated that the existing disclosure requirements did not provide sufficient information to understand an entity’s leasing activities. As a result, the new standard also introduces an overall disclosure objective together with significantly enhanced presentation and disclosure requirements for leases.

Disclosure Objective

FASB Accounting Standards Codification (ASC) 842-20-50-1 and 842-30-50-1 provide that “the objective of the disclosure requirements is to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases.” The standard further indicates that “a lessee [lessor] shall consider the level of detail necessary to satisfy the disclosure objective and how much emphasis to place on each of the various requirements. A lessee [lessor] shall aggregate or disaggregate disclosures so that useful information is not obscured by either the inclusion of a large amount of insignificant detail or by aggregating items that have different characteristics.”[1]

With that objective in mind, significant judgment will be required to determine the level of disclosures necessary for an entity. However, as a guiding principle, the basis for conclusions indicates “if leasing is a significant part of an entity’s business activities, the disclosures would be more comprehensive than for an entity whose leasing activities are less significant….”[2] For example, although the new standard does not provide specific quantitative or qualitative disaggregation requirements such as those required under ASC 606, for entities for which leasing is a significant portion of their business, such disaggregation might be appropriate.

Entities must make appropriate disclosures for each annual reporting period for which a statement of comprehensive income (statement of activities) is presented and in each year-end statement of financial position. Entities are not required to repeat disclosures if the information is already presented in the financial statements as required by other accounting standards.

Although the majority of the disclosures required by ASC 842 only affect an entity’s annual financial statements, the new standard requires that lessors provide a table disclosing lease income for each interim and annual reporting period[3]. Additionally, in the year of adoption, the Securities and Exchange Commission (SEC) requires public companies to include all required annual disclosures in any interim financial statements that are prepared until the next annual financial statements are filed – even if the disclosure requirements are only applicable for annual periods.

Presentation

Lessee A lessee is required to present ROU assets resulting from finance leases separately from ROU assets resulting from operating leases and separately from other assets, either on the face of the balance sheet or in the footnotes. Similarly, lease liabilities for finance leases are required to be presented separately from lease liabilities from operating leases and from other liabilities. In addition, ROU assets are presented as noncurrent in the lessee’s balance sheet, consistent with how other amortizing assets such as PP&E are presented. However, the related lease liabilities are subject to current and long-term presentation requirements in a classified balance sheet, consistent with the way other financial liabilities are presented.

If the lessee chooses to report ROU assets and liabilities within other line items on the balance sheet rather than in separate captions, the lessee is prohibited from reporting finance lease ROU assets or finance lease liabilities in the same caption as operating lease ROU assets and operating lease liabilities. Additionally, disclosure of which line items in the statement of financial position include the ROU assets and lease liabilities would be required.

For finance leases, a lessee should present the interest expense on the lease liability and amortization of the ROU asset in a manner consistent with how the lessee reports other interest expense and depreciation or amortization expense in the income statement. For operating leases, the lessee must present both components together as lease expense within income from continuing operations, consistent with the presentation of other operating expenses. Lease expense should be classified within cost of sales; selling, general, and administrative expense; or another expense line item depending on the nature of the lease.

The new standard does not provide specific guidance on the presentation of variable lease payments (for either finance or operating leases). Paragraph BC271 in the basis of conclusions for ASU 2016-02 indicates that amount recognized in the income statement should be presented within income from continuing operations. We believe that presentation as either lease expense or interest expense may be appropriate, depending on the nature of the lease. In making this determination, lessees should assess whether the payments are more akin to lease payments or interest.

The cash flow classification of payments related to finance leases should be consistent with the classification of payments associated with other financial liabilities. Payments of principal should be presented as financing activities, while payments of interest would typically result in operating cash flow presentation. Payments related to operating leases, leases to which the lessee has applied the practical expedient for short term leases, and any variable lease payments for either operating or finance leases should all be classified as operating cash outflows (unless the payment represents a cost of bringing another asset to the condition and location necessary for its intended use, in which case it should be classified within investing activities). Additionally, the establishment of ROU assets and lease liabilities at inception of a lease (or that change as a result of lease modifications or reassessment events) should be disclosed as noncash investing and financing activities.

Lessor A lessor is required to present lease assets (i.e., net investment in leases) resulting from sales-type and direct financing leases separately from other assets in the balance sheet. Lease assets are financial assets that are subject to current and long-term presentation requirements in a classified balance sheet.

For operating leases, the assets underlying the leases and related depreciation are presented in accordance with other accounting guidance (e.g., ASC 360). Assets subject to lease under operating leases should be presented separately from owned assets that are held and used by the lessor as they are subject to different risks. Any rent receivable, deferred rent revenue (i.e., that results from requirement to recognize rents on a straight-line basis), or prepaid initial direct costs would be subject to current and long-term presentation requirements.

Income arising from leases should be presented separately in the income statement or in the footnotes. If presented in the footnotes, a lessor must also disclose which line items include lease income. Revenue and cost of goods sold related to profit or loss on leases recognized at the commencement date should be presented on a gross basis if the lessor uses leases as an alternative means of realizing value from goods that it would otherwise sell. If the lessor uses leasing as a means of providing finance, profit or loss should be presented on a net basis (i.e., as a single line item).

The new standard does not provide specific guidance on the presentation of variable lease payments received for direct financing or sales type leases. We believe that presentation as either lease income or interest income may be appropriate, depending on the nature of the lease. In making this determination, Lessors should assess whether the payments are more akin to lease payments or interest.

Lessors must classify all cash receipts from leases as operating activities in the statement of cash flows.

As noted previously, the objective of the disclosure requirements in the new leasing standard is to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. To help entities achieve this objective, the leasing standard prescribes quantitative and qualitative disclosures that are required for all entities.[4]

The following table summarizes the disclosure requirements of the leasing standard:

Sale and Leaseback

If a seller-lessee enters into a sale and leaseback transaction, it must provide the disclosures required for lessees. Similarly, a buyer-lessor must provide the disclosures for lessors. Additionally, a seller-lessee must disclose the main terms and conditions of the sale and leaseback transaction and must disclose any gains or losses arising from the transaction separately from gains or losses on disposal of other assets.

Leveraged Leases

Although ASC 842 removed leveraged lease accounting, leases that met the definition of a leveraged lease under ASC 840 that commenced before the effective date of ASC 842 are grandfathered in. As such, entities that continue to have leveraged leases must continue to provide disclosures as required by ASC 842-50, which carries forward existing guidance from ASC 840.

Other Disclosure Considerations

Transition The leasing standard requires an entity to provide the general disclosures required by ASC 250 Accounting Changes and Error Corrections. Entities are also required to provide an explanation to users of financial statements about which practical expedients were used in transition.

SAB 74 Disclosures In periods prior to adoption of the leasing standard, entities are required to make disclosures under the SEC’s Staff Accounting Bulletin No. 74 (codified in SAB Topic 11.M), Disclosure Of The Impact That Recently Issued Accounting Standards Will Have On The Financial Statements Of The Registrant When Adopted In A Future Period (“SAB 74”). SAB 74 requires that when a recently issued accounting standard has not yet been adopted, a registrant disclose the potential effects of the future adoption in its interim and annual SEC filings. SAB 74 disclosures should be both qualitative and quantitative. According to Center for Audit Quality Alert 2017-03, SAB Topic 11.M – A Focus on Disclosures for New Accounting Standards, the SEC staff expects that SAB 74 disclosures will become more robust and quantitative as the new accounting standard’s effective date approaches. As such, the following types of SAB 74 disclosures are expected in a registrant’s financial statements in the periods before new accounting standards are effective:

• A comparison of accounting policie s . Registrants should compare their current accounting policies to the expected accounting policies under the new accounting standard(s).
• Status of implementation. The status of the process should be disclosed, including significant implementation matters not yet addressed or if the process is lagging.
• Consideration of the effect of new footnote disclosure requirements in addition to the effect on the balance sheet and income statement. A new accounting standard may not be expected to materially affect the primary financial statements; however, it may require new significant disclosures that require significant judgments.
• Disclosure of the quantitative impact of the new accounting standard if it can be reasonably estimated.
• Disclosure that the expected financial statement impact of the new accounting standard cannot be reasonably estimated.
• Qualitative disclosures. When the expected financial statement impact is not yet known by a registrant, a qualitative description of the effect of the new accounting standard on the registrant’s accounting policies should be disclosed.

Selected Financial Data – 5 Year Table

Some SEC registrants have questioned whether they must recast all periods reflected in the 5 year Summary of Selected Financial Data in accordance with the new leasing standard? In short, the answer is “no”. Registrants are only required to adjust the periods in the financial data table that correspond to the periods adjusted in the registrant’s financial statements. For example, an entity that elects to adopt the new standard as of the effective date (i.e., without restating prior comparative periods), the four prior years in the selected financial data table would not be adjusted. Companies will be required to provide the disclosures required by Instruction 2 to S-K Item 301 regarding comparability of the data presented.

Appendix A – Disclosure Example – LESSEE

Background For purposes of this example, we have assumed that Susie’s Stitch-n-Sew (“Susie’s”) is a national retailer of fabrics and other craft materials which primarily leases its retail locations. We have not presented a statement of financial position, but have assumed that Susie’s has presented the following captions:

• Operating lease ROU assets
• Fixed assets, net
• Current portion of operating lease liabilities
• Long-term operating lease liabilities
• Current portion of long-term debt
• Long-term debt

We have also not presented a statement of comprehensive income, but have assumed that Susie’s has presented Cost of sales, SG&A expense, Depreciation and amortization expense, and Interest expense. This example assumes that the guidance in ASC 842 has been in effect for all periods presented, and that all amounts are in millions.

Note X. Leases Susie’s has historically entered into a number of lease arrangements under which we are the lessee. Specifically, of our 250 retail locations, 240 are subject to operating leases and 5 are subject to finance leases. In addition, we lease our corporate headquarters facility, as well as various warehouses and regional offices. We are also a party to an additional 12 leases in which we previously operated a retail location, but which are now subleased to third parties. In addition, we have elected the short-term lease practical expedient related to leases of various equipment used in our retail locations.

As of December 31, 20X9, we have entered into eight leases for additional retail locations and one lease for an additional warehouse which have not yet commenced. Although certain of the retail locations are currently under construction, we do not control the building during construction, and are thus not deemed to be the owner during construction.

All of our retail leases include multiple optional renewal periods. Upon opening a new retail location, we typically installs brand-specific leasehold improvements with a useful life of eight years. To the extent that the initial lease term of the related lease is less than the useful life of the leasehold improvements, we conclude that it is reasonably certain that a renewal option will be exercised, and thus that renewal period is included in the lease term, and the related payments are reflected in the ROU asset and lease liability. Generally, we do not consider any additional renewal periods to be reasonably certain of being exercised, as comparable locations could generally be identified within the same trade areas for comparable lease rates.

All of our leases include fixed rental payments, but many of our leases also include variable rental payments. Specifically, a number of our leases in certain markets require rent payments that are calculated as a percentage of sales in that location. In addition, we also commonly enter into leases under which the lease payments increase at pre-determined dates based on the change in the consumer price index. While the majority of our leases are gross leases, we also have a number of leases in which we make separate payments to the lessor based on the lessor’s property and casualty insurance costs and the property taxes assessed on the property, as well as a portion of the common area maintenance associated with the property. We have elected the practical expedient not to separate lease and nonlease components for all of our building leases.

During 20X9, 20×8 and 20×7, we recognized rent expense associated with our leases as follows:

Amounts recognized as right-of-use assets related to finance leases are included in Fixed assets, net in the accompanying statement of financial position, while related lease liabilities are included in Current portion of long-term debt and Long-term debt.  As of December 31, 20×9 and 20×8, right-of-use assets and lease liabilities related to finance leases were as follows:

During the years ended December 31, 20×9, 20×8 and 20×7, we had the following cash and non-cash activities associated with our leases:

The future payments due under operating and finance leases as of December 31, 20×9 is as follows:

As of December 31, 20×9 and 20×8, the weighted-average remaining lease term for all operating leases is 3.4 years and 3.5 years, respectively, while the weighted-average remaining lease term for all finance leases is 4.9 years and 5.6 years, respectively.

Because we generally do not have access to the rate implicit in the lease, we utilize our incremental borrowing rate as the discount rate.  The weighted average discount rate associated with operating leases as of December 31, 20×9 and 20×8 is 4.2% and 4.0%, respectively, while the weighted-average discount rate associated with finance leases is 3.9% and 3.8%, respectively.

For questions regarding FASB Topic 842 please contact Sean Spitzer or another member of Smith and Howard’s Assurance Services Group by completing the contact form below at calling 404-874-6244.

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A guide to lease accounting

Download the guide.

A guide to lease accounting under ASC 842  assists middle-market lessees and lessors in applying the lease guidance in Topic 842,  Leases , of the Financial Accounting Standards Board’s Accounting Standards Codification (ASC).

Our comprehensive guide includes in-depth discussion and numerous examples on:

• The scope of ASC 842, whether a contract is within the scope of ASC 842 and the definition of a lease
• The steps entities should take in identifying the units of account present in a contract that includes a lease and allocating the contract consideration to those units of account
• The determination of whether the lease and non-lease components should be treated as separate units of account
• The key inputs used by entities in classifying and accounting for a lease, including the commencement date, the discount rate, the lease term and lease payments
• The lease classification criteria used by entities to classify a lease under ASC 842
• The application of the appropriate accounting model in ASC 842 to the lease (which depends on its classification)
• The initial and subsequent accounting by lessees for operating leases and finance leases, including specific issues such as evaluating ROU assets for impairment, applying ASC 842 to leases denominated in a foreign currency and recognizing leases acquired in business combinations and asset acquisitions
• The initial and subsequent accounting by lessors for sales-type leases, direct financing leases and operating leases
• The seller-lessee’s evaluation of and accounting for sale-leaseback transactions
• The entity’s presentation of leases on its balance sheet, income statement and cash flows statement and the disclosures required of lessees and lessors under ASC 842
• The effective date of ASC 842 and the transition guidance that should be applied in the initial implementation of ASC 842

We also shine spotlights throughout our guide on a variety of middle market insights regarding ASC 842 . In addition, we provide: (a) an easy-to-use table that summarizes the reassessment and remeasurement events that require reassessment or remeasurement of a particular aspect of ASC 842 (e.g., reassess lease classification or remeasure lease payments) and (b) a disclosure checklist.

The December 2023 edition of this guide has been updated to incorporate guidance from the following Accounting Standards Updates (ASUs) issued by the FASB:

• ASU 2022-06, Reference Rate Reform (Topic 848): Deferral of the Sunset Date of Topic 848 (see Section 7.2.5.5 of the guide)
• ASU 2023-01, Leases (Topic 842): Common Control Arrangements (see Sections 3.1.1 and 10.3.4 of the guide)
• ASC 326-20, Financial Instruments – Credit Losses – Measured at Amortized Costs (see Sections 7.5, 7A.2.4 and 7A.2.7 of the guide)

This edition also has been updated to add Appendix E: Definitions and to incorporate RSM’s October 2022 Lessor accounting under ASC 842 whitepaper for one comprehensive lease accounting guide.

Our guide is a valuable tool for entities as they apply the guidance in ASC 842 and account for their leases on a going-forward basis.  Click here for information about the ASC 842 accounting standards implementation services  provided by RSM.

Do you know how to evaluate ASC 842 technology solutions?

Asc 842 represents a significant shift in lease accounting standards and many technology solutions can ease the transition and help organizations remain compliant., subscribe to financial reporting insights, stay informed with our biweekly resource for recent financial reporting developments, including aicpa, sec, pcaob matters and other finance and accounting compliance considerations. .

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Presentation and Disclosure of Leases (IFRS 16)

Last updated: 16 November 2023

Statement of financial position

Under IFRS 16.47-48, right-of-use assets and lease liabilities must either be presented separately in the statement of financial position or disclosed in the accompanying notes. If not separately presented, right-of-use assets should be included in the same line item as that applicable to the underlying assets.

Statement of profit or loss

The depreciation charge for right-of-use assets must be presented in the same manner as depreciation or amortisation for assets accounted for under IAS 16 and IAS 38. Notably, IFRS 16 does not mandate a separate presentation for the depreciation of right-of-use assets.

Interest expense related to lease liabilities is to be reported as part of finance costs (IFRS 16.49).

Statement of cash flows

The impact of leases on the statement of cash flows includes (IFRS 16.50):

• Repayments of the principal portion of the lease liability, presented within financing activities.
• Payments related to accrued interest, classified according to the accounting policy for interest payments.
• Short-term lease payments and payments for low-value asset leases , presented in operating activities if the lessee has adopted the relevant recognition exemption.
• Variable lease payments not included in the lease liability measurement, also presented in operating activities.

Are you tired of the constant stream of IFRS updates? I know it's tough! That's why I created Reporting Period – a once-a-month summary for professional accountants. It consolidates all essential IFRS developments and Big 4 insights into one readable email. I personally curate every issue to ensure it's packed with the most relevant information, delivered straight to your inbox. It's free, with no spam, and if it turns out not to be right for you, you can unsubscribe with just one click.

For lessees, disclosure requirements are detailed in IFRS 16.51-60 and IFRS 16.B48-B52. Interestingly, all lease-related information should be consolidated into a single note or a dedicated section within the financial statements, although cross-referencing is permitted (IFRS 16.52). For illustrative examples, refer to Examples 22 and 23 accompanying IFRS 16.

More about IFRS 16

See other pages relating to IFRS 16:

© 2018-2024 Marek Muc

The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Excerpts from IFRS Standards come from the Official Journal of the European Union (© European Union, https://eur-lex.europa.eu). You can access full versions of IFRS Standards at shop.ifrs.org. IFRScommunity.com is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org.

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How to Calculate the Lease Liability and Right-of-Use Asset for an Operating Lease under ASC 842

What is an operating lease.

This post assumes some prior knowledge. If you're unaware of the new lease accounting standard, ASC 842, here's a quick  summary . 

Akin to ASC 840, the new lease accounting standard ASC 842 prescribes the lessee to determine the lease classification. However, under ASC 842, it's no longer the classification between operating leases and capital leases. It's now operating leases and finance leases. 

When transitioning to the new lease accounting standard, the standard allows you to grandfather previous lease classification under ASC 840. For more on this, refer  here . This means the operating leases under ASC 840 can be carried forward as operating leases under ASC 842. 

If it's a new lease under ASC 842 and you're unsure what the classification should be, we have extensive  material  in determining if the lease meets the definition of an operating or finance lease.

Under ASC 842, regardless of the lease classification, the lease is coming on the balance sheet . A lessee must recognize a right-of-use (ROU) asset and lease liability. The only exception is if the lease is less than twelve months long. Given this, accountants in your organization will need to know how to calculate an operating lease in compliance with ASC 842. 

Accounting for an Operating Lease Under ASC 840

Previously, accounting for operating leases under ASC 840 was relatively straight forward. Under ASC 840-20-25-1, it prescribed the following treatment:

Rent shall be charged to expense by the lessee over the lease term as it becomes payable.  If rental payments are not made on a straight-line basis, rental expense nevertheless shall be recognized on a straight-line basis unless another systematic and rational basis is more representative of the time pattern in which use benefit is derived from the leased property, in which case that basis shall be used. 

From the perspective of accounting simplicity, the preferred classification was an operating lease under ASC 840. 

Accounting for an Operating Lease Under ASC 842

ASC 842 requires lessees to bring all leases on the balance sheet.  The only exception is if at lease commencement, the lease term of 12 months or less.

So what does this mean? It's essentially like accounting for all your leases as if they were capital leases under ASC 840. Under ASC 842, an operating lease you now recognize: 

• A lease liability: the present value of all known future lease payments
• Right of use asset: the lessee's right to use the leased asset. Which is amortized over the useful life of the asset. 

So, where to begin? If you're unsure, refer to our initial recognition guidance. This covers the fundamentals inputs of recognizing a  lease liability  and then a  right of use asset . 

Modification Accounting for an Operating Lease Under ASC 842

The devil is in the detail when calculating modifications. If you’re unsure of what a lease modification is, refer to detailed guidance  here . 

When a modification occurs, the lease calculation must be updated to reflect the changes in contractual details. The two inputs that can be changed are:

• Lease payments

Either or both can change depending on the modification. When a lease modification occurs, you must update the present value calculation to reflect the updated lease liability value as the future payments have been changed. 

Example 2 illustrates how to calculate the lease liability and right of use asset when a lease modification occurs.

Practical Examples

So you’ve read the guidance, and now you’re good to go. You have a basic understanding that the lease liability is the present value of the future lease payments at commencement. The right of use asset builds off that value, with a few other potential nuances throw-in. 

So it’s time to put theory into practice and calculate the lease liability. We’ll walk through step by step of a basic lease example.  If you would like a copy of the lease calculation in excel, please reach out to [email protected] . Obtaining the excel file will also allow you to use it as a template for future lease calculations.

Lastly, some areas to note in relation to the calculation methodology: 

• Calculations will be done daily : that’s right, interest and amortization are calculated for each individual day in the lease. This gives the ultimate accuracy of numbers when modification accounting occurs. Furthermore, the time to set up a daily calculation compared to a monthly calculation is negligible given it’s the same formulas used in each row. 
• XNPV present value formula : The XNPV formula will be used in Microsoft Excel. This takes into consideration the date of payments and therefore gives a more accurate present value amount. 

If you’re unsure of the basic principles of present valuing or unsure what formula you should use in Microsoft Excel, refer to our article on How to Calculate the Present Value of Future Lease Payments.

Example 1 Scenario

• Start date: 2020-1-1 
• Accounting End date: 2020-12-31
• Fixed Payment Amount: $10,000
• Payment Timing: In Advance
• Payment Frequency: Monthly
• Lease classification: Operating Lease
• Discount rate: 7.00%

Step 1 - Work Out Future Lease Payments

The lease liability is the foundation of lease accounting under ASC 842, as the lease liability is the present value of future lease payments. So the first input of the calculation to figure out is  what are future known lease payments at commencement. These are the figures we are going to use to establish the present value . 

Refer  here  for explicit guidance of what should be included in the lease payments. In reference to Example 1, it is 12 payments of $10,000 falling on the first of each month for the period between 2020-1-1 to 2020-12-31.

Step 2 - Determine the Discount Rate and Calculate the Lease Liability

From an accounting judgement perspective, this is one of the more complex areas of lease accounting. For further information on how to determine the appropriate discount rate refer to this material . 

Once you have determined the discount rate, you have all the inputs to complete the XNPV formula in Microsoft Excel. In reference to Example 1, the discount rate is 7%. As a result, in the XNPV formula you will input:

• Values: $10,000 at the start of each month
• Dates: 2020-1-1 to 2020-12-31

Inputting this data will give you the present value of the future lease payments of $116,357.12 . This is the lease liability amount at initial recognition.

Step 3 - Calculate the Right-of-Use Asset Value

The lease liability is the foundation of the right of use asset. When calculating the right of use asset value, it can consist of several inputs. For further discussion of those inputs, refer here . 

In the above example, it’s straightforward, the right of use-value equals the lease liability value of $116,357.12

Step 4 - Calculate the Unwinding of the Lease Liability

You now have your opening balance for the lease liability and ROU asset calculated in compliance with ASC 842. The next step is to calculate the unwinding of the lease liability to $0. We already have all the necessary information given there have been no modifications to the lease term.

We’ll break down the calculation in reference to the above picture column by column. The formulas used do not change row to row:

Column A - Date - Captures each day within the agreement from 2020-1-1 to 2020-12-31:

Column B -Lease liability prepayment- Where the present value XNPV formula is input for each row:

Column C - Payment - Future lease payments at each particular date:

Column D - Lease liability post-payment - This is the lease liability amount post-payment. Payments reduce the lease liability balance:

Column E -Interest- This is the daily interest amount calculated on the lease liability based on the daily discount rate:

To calculate the daily discount rate is the following:  (1+discount rate)^(1/365)-1

Column F - Lease liability closing - the lease liability post-payment plus the interest. It is the closing balance of the lease liability. This balance is brought forward to the next day:

To ensure your lease liability has been calculated correctly ensure it unwinds to zero as shown in the below animation:

Step 5 - Calculate the Right-of-Use Asset Amortization Rate

You have calculated the unwinding of the lease liability and have the ROU asset opening value. Here are the following steps to take when calculating the ROU asset amortization schedule:

a) Calculate the straight-line lease payment:

Add up the total lease expense that is known at the outset of the commencement of the lease. The total lease expense is net of items like direct costs and lease incentives starting before the commencement.

Using Example 1 the total lease expense is $120,000 ($10,000*12).

Area to note : If there is an amount that is added to the ROU asset, for example, direct costs, this amount will also be added to the straight-line lease payment amount.

b) Calculate the number of days in the agreement:

A quick way to do this in Excel is to use the COUNT function and count the number of rows used (it can be any column). Using Example 1 the total number of days in the lease is 366 days (2020 is a leap year).

c) Divide total expense by number of days to get the straight-line lease expense 

Using Example 1 the straight-line lease expense is $327.87 (120,000 / 366)

d) Subtract the daily straight-line lease expense by the daily interest expense which gives you the amortization expense

Using Example 1 on 2020-1-1 the ROU amortization expense is $308.15 ($327.87 - 19.72)

e) Ensure the ROU asset is amortized to $0

Assuming there are no changes you have now completed the calculation for an operating lease in adherence to ASC 842.

Example 2 Scenario - Modification Accounting

Example 2 will cover how the calculations work for a particular modification to an operating lease terms accounted under ASC 842. If you want more information on what prompts modification accounting and the different types of lease modifications, refer  here . 

We’ll now go through the following calculation steps of a modification that increases the fixed payments for an operating lease under ASC 842. 

Using the details of Example 1:

• Direct costs incurred: 25,000

Modification to the terms:

• On 2020-10-16, the fixed payment amount increased to $12,000 on 2020-11-1
• The appropriate discount rate at modification is 6.00% 

The key differences compared to Example 1 are: 

• Direct costs of $25,000 at initial recognition: This will increase the ROU asset to 141,357.12 ($116,357.12 + $25,000) and the straight line lease payments to 396.17 ($25,000 + 120,000)/366. 
• A modification of the lease agreement occurs on 2020-10-16 for fixed payments to increase to $12,000 starting on 2020-11-1

If you would like the excel calculation for Example 2, please reach out to  [email protected]

Step 1 - Work Out the Modified Future Lease Payments

To calculate the present value of the modified future lease payments, an additional column has been added. If you do not add a column, it will impact all previous calculations as you’re changing the future cash flows used to present value the lease liability. In reference to Example 2, on 2020-10-16 the future lease payments on 2020-11-1 and 2020-12-1 have been modified from $10,000 to $12,000.

Step 2 - Determine the Appropriate Discount Rate and Re-calculate the Lease Liability

In relation to Example 2, the following have changed in relation to the calculation on 2020-10-16:

• An updated discount rate of 6% in CELL D5
• Values: The XNPV formula values will present value the updated future payments of Column D.

Based on adding a new column the following updates will need to be made to the calculation:

a) Lease liability post payment will subtract payments from column D as opposed to column C:

b) Daily interest calculation will use the updated daily discount rate:

In Example 2, the discount rate has increased from 6% to 7%. As a result, the daily discount rate for calculating the interest on the lease liability needs to be updated.

Once you have determined the discount rate, you have all the inputs to complete the updated lease liability's present value calculation based on the modified terms. 

As a check, ensure the lease liability post modification unwinds to $0 based on the updated lease inputs. 

If you’ve forgotten to make the correct updates to the calculation the lease liability will not unwind to zero by 2020-12-1. 

Step 3 - Capture the Modification Movement and Apply That to the ROU Asset Value

The closing balance of the lease liability before the modification on 2020-10-15 is $19,885.48. The lease liability value post modification based on the updated future cash flows is $23,881.59, which is an increase of  $3,996.11 to the lease liability value . This amount needs to be added to the ROU Asset as that’s the other side of the remeasurement journal entry which is: 

Dr  ROU Asset $3,996.11

Cr  Lease liability $3,996.11 

As a result, the ROU asset balance before modification on 2020-10-15 was $30,390.94. Post-modification, the ROU asset balance is $34,387.05.

Step 4 - Update the ROU Amortization Rate

When there is a change to the contractual terms, it results in a remeasurement of the lease liability, which then the ROU Asset value is impacted. As a result, the amortization rate must change to ensure the ROU asset is amortized to zero. This is one of the trickier areas of accounting for an operating lease under ASC 842.

To ensure the balance is correctly amortized to $0 you must:

a) Calculate the total remaining lease expense:

In Example 2 the total lease expense is $24,000 with two lease payments occurring on 2020-11-1 & 2020-12-1.

b) Calculate the difference between the ROU asset and the lease liability post-modification:

In reference to Example 2, the ROU asset post-modification is $34,387.05 while the lease liability is $23,881.59 resulting in a difference of $10,505.46

c) Calculate the number of remaining days of the useful life of the asset:

In Example 2, it is 77 days which is calculated from the date of modification 2020-10-16 to the accounting end date 2020-12-31.

From those inputs you can calculate the average rent expense for the remainder of the lease: 

• Total expense: $24,000
• Difference between ROU and lease liability post modification: $10,505.46
• Remaining days: 77 

Straight line lease payment: $448.12 (24,000 + 10,505.46) / 77

Subtract the $448.12 from the daily interest amount to get the ROU amortization amount. The amount of amortization incurred on 2020-10-16 was $444.31. To ensure the calculation is correct, the ROU asset should be amortized to $0 on 2020-12-31. 

Once those steps are complete you have finished the calculations necessary for a modification of an increase in fixed payments for an operating lease under ASC 842.

What About the Journal Entries?

If you're curious as to what are the journal entries for an operating lease under ASC 842 refer to the article The Journal entries for an operating lease under ASC 842 .

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New lease accounting: Top 10 FAQs surrounding ASC 842

What seemed like a topic that was always in the distant future is now upon us: accounting standards update (ASU) No. 2016-02, Leases (ASC 842). 

Under previous rules, lessees typically accounted for lease transactions as off-balance sheet operating leases or on-balance sheet finance leases. Under the new standard, lessees will have to recognize nearly all leases on the balance sheet. 

ASU 2016-02 comes on the heels of Revenue Recognition (ASC 606) and presents another wide-reaching and major change to the accounting world. Under ASU 2016-02, balance sheets will swell as nearly all leases will now be capitalized. Overall the ASU is very complex; however, below are some frequently asked questions that we are seeing from our clients and the industry. Like most things, the devil is in the details, but the below Q&A can provide high-level answers to these burning questions. 

1. When is the standard effective?

ASU 2016-02 is effective for public companies in 2019 and private companies in 2022. 

2. What are the changes to how capital leases (now known as “finance leases”) are presented?

The general accounting for finance leases remains largely unchanged compared to the legacy presentation of capital leases.

On the balance sheet, the finance leased asset is typically recorded as part of property, plant and equipment (PP&E), and the lease liability is recorded as funded debt. From a profit and loss perspective, the leased asset is depreciated over the shorter of the term or asset’s useful life, and interest expense is front-loaded as the lease obligation is amortized.

3. How will operating leases now “look” on the balance sheet?

Operating leases take on an entirely new look under ASC 842 in that a right-of-use (ROU) asset and liability are recorded by calculating the present value (PV) of the lease payments using the appropriate discount rate.

Balance sheet presentation of a ROU asset is classified as a long-term asset on a separate line item outside of PP&E. Furthermore, the ROU lease obligation will need to be separated into short-term and long-term liabilities that are aside from funded debt. The profit and loss components of a ROU asset and corresponding liability are amortized under the straight-line method and presented together as rent or lease expense.

Under ASC 842, neither amortization of the ROU obligation nor the ROU asset is considered interest expense or depreciation expense, leaving EBITDA unchanged from accounting for operating leases under the prior lease standards. 

4. Does the standard change the way we determine which type of lease we have?

There will continue to be two types of leases: finance (formerly known as capital) and operating. However, both will require recognition of an asset and a liability on the balance sheet. The differentiation between the two types of leases will play a significant role as to balance sheet classification but does not come without significant analysis in determining what type of lease it actually is. 

Finance leases will no longer be evaluated using the “bright-line” tests. Rather, they will be evaluated using principles-based criteria, which aim to evaluate the underlying substance of the lease. The principles-based criteria certainly involve a level of subjectivity; however, the finance lease classification applies should any of the following be met:

• The property transfers to the lessee at the end of the lease.
• The lessee is reasonably certain to exercise a purchase option.
• The lease term is for a “ major ” part of the asset’s economic life.
• The present value of lease payments equals or exceeds “ substantially all ” of the fair value of the asset (undoubtedly the most subjective — more on this later).

If the lease does not meet the above criteria, it will be considered an operating lease. 

5. What changes for lessors vs. lessees?

From the lessor’s point of view, not much changes. In contrast, lessees will now be required to capitalize all leases with terms greater than 12 months. 

6. Why is the FASB doing this?

Think about this: Prior to this standard, airlines had not been recording their airplanes on their balance sheets! The standard provides better clarity to users of the financial statements via recognition and measurement of a company’s leased assets and associated liabilities that have historically been tucked away in a footnote disclosure.

7. How do I determine the discount rate?

This is where things can get tricky! To determine the PV, lessees should use the implied rate in the lease contract (if known) or the company’s incremental borrowing rate. This rate is based on what rate the company would obtain if financing 100% of the underlying asset using similar terms and pledging the asset as collateral.

Knowing that this is often difficult to determine, private companies are afforded an election to use the risk-free rate (e.g., Treasury bill). However, this comes with caution as it typically results in a higher PV, leading to a larger corresponding asset and liability to be booked. 

8. Are there new disclosures required?

The footnote disclosure under current standards doesn’t afford financial statement users with many details on either type of lease; however, this is changing. Under ASC 842, the disclosure will provide the reader with both quantitative and qualitative information as to how the lease classification was determined. This information will help the reader comprehend significant judgments and assumptions that were used in evaluating leases under the principles-based criteria. 

9. How will this impact my loan covenants?

With operating leases now on the balance sheet, various financial metrics, including those commonly used in loan covenants, are sure to change. The measures of working capital, quick ratio, current ratio and any metrics related to debt (i.e., funded debt) will need to be reviewed carefully to understand how newly capitalized leases will influence results.

In calculations involving EBITDA, the change should not impact results as interest and depreciation (associated with finance leases) are added back, and operating leases (presented as rent or lease expense) are commonly excluded from the benchmark. 

Needless to say, it will be imperative to be proactive with your banker. Covenants should be analyzed to determine the impact of the new standard. Some lenders are changing agreements to use updated metrics, while some are simply adding wording to the covenant calculation that says, “Under GAAP in place as of the date of this agreement.” That may seem to simplify things; however, it may also require you to keep two sets of books and records, which can get complicated. 

10. How do I prepare for these changes?

The first step is to digest the change in standards and the ripple effect that will come from capitalizing substantially all leases. This will involve an evaluation of the appropriateness of systems, procedures and controls necessary to accumulate and track pertinent lease information. Determination will need to be made as to adoption of ASC 842, which is available on a modified retrospective basis or through a cumulative effect adjustment as of the beginning of the year of adjustment.

A proactive approach to the change in lease accounting is certain to help reduce the burden and headaches of another significant change in accounting standards. If you haven’t done so already, you should start your process in a variety of ways, including knowledge transfer sessions, the evaluation of lease contracts and interpreting the impacts on financial statement presentation and disclosures. Reach out to Wipfli for further assistance in understanding ASU 2016-02.

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Operating Leases: Understanding how to report them on your balance sheet

Yes, a significant change will be appearing on your financial statements if you have operating leases. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 842, Leases, is effective for private companies and nonprofit organizations annual reporting periods beginning after December 15, 2021. For most of us, this change will impact the financial statements dated December 31, 2022, or later. The main objective of the standard is to improve financial reporting by enhancing transparency of leasing obligations; in particular, operating lease contracts. Per ASC 842, a lease is a contract granting control of an identifiable asset for a specific period in exchange for payment. For example, if you lease a building or vehicle, then you have an asset that needs to be identified as an asset over the length of the lease. Finance leases, also known as leases, that include the purchase of the item leased, have previously been, and will continue to be, required to be recorded on the balance sheet.  Operating leases have been treated as off-balance sheet transactions, which means, they were not recorded on the balance sheet. However the payment obligation of the lease contract is a liability to your organization and is not shown as something you owe on your balance sheet. After adoption of the standard, operating leases will be recorded on the balance sheet as well.  A lease will be recorded on the balance sheet as a right-of-use (ROU) asset and lease liability. The lease liability is the payment obligation over the term of the lease contract, while the ROU asset represents the control of the asset under the lease contract. The asset and liability of operating leases need to be presented separately from finance leases, either on the face of the balance sheet or in the notes to the financial statements. For example, let’s look at a building lease, the asset will be the building and the liability will be the lease payments, both shown on your balance sheet.  The ROU asset, the building in our example, is amortized over the term of the lease and, unless the initial term of the lease is twelve months or less, will be presented as a long-term asset on the balance sheet. The lease liability, the lease payments in our example, is subject to the classification between current and long-term liabilities. On the income statement, the amortization, or reduction in the value, of the ROU asset will be recognized as an expense. No change in the treatment of interest expense on finance leases.

Overall, no significant change in the presentation of finance leases. The standard impacts operating leases. Depending on the types and quantity of operating leases your organization is committed to would influence our recommendations for best practice on implementing the new lease accounting standard. For further guidance please contact ADKF and we would be glad to assist you in your preparation of the adoption of the standard.

ADKF is the largest, locally owned public accounting firm in San Antonio, Texas, with branch offices in Boerne and New Braunfels. We have been serving our community since 1991. We are a full-service CPA firm dedicated to providing a broad range of tax, audit, bookkeeping, tax controversy, and consulting services with superior customer service to help our clients meet their goals and objectives. Please click here to set an appointment with us.

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Operating Lease Accounting Under ASC 842 Explained With a Full Example

April 26, 2023 • HoganTaylor

Lease Accounting Publications

Operating lease treatment under ASC 842 vs. ASC 840: What changed?

Under ASC 840 , operating leases were considered off-balance sheet transactions . The rent expense associated with the arrangements was recognized in the income statement, but nothing was recorded on the balance sheet. This made it difficult to understand the total amount of commitments a company had. It could also make comparisons between companies difficult, depending on their different approaches to leased vs. capital assets.

To increase transparency, the FASB issued ASC 842, Leases . One of the main provisions of this new standard is that all leases must be recognized on a company’s balance sheet. For operating leases, ASC 842 requires recognition of a right-of-use asset and a corresponding lease liability upon lease commencement.

With the changes introduced under ASC 842, all leases are now presented on both the balance sheet and income statement whether they are operating or finance (capital) leases . The updated financial statement presentation requires issuers to show the operating ROU asset and operating lease liability separately from the finance (capital) ROU asset and lease liability both on the face of the financials and in the notes disclosures.

However, the effect of operating leases on the income statement is not changing. Companies will continue to recognize a straight-line expense for the lease payments made over the lease term as an operating expense on the statement of profit and loss.

Operating lease vs. finance lease identification under ASC 842

Operating vs. finance lease classification under ASC 842 is relatively similar to the operating lease vs. capital lease criteria under ASC 840, but certain “bright lines” for classification have been removed, consistent with the more “principles-based” approach of ASC 842. For a lease to be classified as a finance lease , it must meet one of the five criteria listed below. If the lease does not fall under any of these criteria, it is classified as an operating lease:

1. Transference of title/ownership to the lessee

Ownership of the underlying asset is transferred to the lessee by the end of the lease term.

2. Purchase option

The lease arrangement grants the lessee an option to purchase the asset , which is reasonably certain to be exercised. It is important to note, the purchase option must be reasonably certain to be exercised for this criteria to met.

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

The lease term spans a major part of the remaining economic life of the underlying asset.

Note: The FASB provided additional clarification that “major part” can be consistent with the 75% threshold used under ASC 840. Companies are allowed to determine how they will define the “major part” threshold . In practice, though, a large portion of organizations tend to lean towards using the 75% threshold previously seen in ASC 840.

4. Present value represents “substantially all” of the fair value of the asset

The present value of the sum of the remaining lease payments equals or exceeds substantially all of the underlying asset’s fair value. If applicable, any residual value guarantee by the lessee not already included in lease payments is also included in the present value calculation.

Note: The FASB provided some additional clarification that “substantially all” can be consistent with the 90% threshold used under ASC 840. Here also, companies are allowed to determine their own “substantially all” threshold, but in practice the majority of entities are continuing to use 90%.

5. Asset specialization

The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

Is lease capitalization required for all operating leases under 842?

An entity can establish an accounting policy to exclude operating leases with a lease term of 12 months or less at lease commencement (provided they also do not have a purchase option that is reasonably certain of exercise) from capitalization on the balance sheet . Further, while ASC 842 does not have an exclusion for low-value assets, some companies have established a capitalization threshold. Similar to a capitalization threshold for fixed assets , the company has determined that leases below this value are not material to the company and therefore, are not recognized on the balance sheet.

Operating lease accounting example and journal entries

The following is a full example of how to transition an operating lease initially recorded under ASC 840 to ASC 842 accounting treatment.

Details on the example lease agreement:

First, assume a tenant signs a lease document with the following terms:

The lease begins on April 1, 2016 (commencement date) and continues for 120 full calendar months. The tenant is granted access to the premises 60 days prior to the commencement date to install equipment and furnishings (the “early access period”). Such access is subject to all the terms and conditions of this lease, except that the commencement date and the payment of rent shall not be triggered thereby.

Tenant improvement allowance

The tenant received a tenant improvement allowance , or TIA , of $1.2 million from the landlord as an incentive to sign the lease . The landlord paid the contractor directly for the construction of the improvements, which were constructed prior to the early access period.

Moving expenses

The tenant also received a reimbursement of $30,000 for moving expenses from the landlord.

Per the lease document, the first rent payment is due three full calendar months after the tenant begins operating at the leased location. Base rent is $205,000/month paid in arrears; with annual 3% increases on the anniversary of rent commencement.

Assumptions

Assume the lease is classified as an operating lease and the fair value of the building is $300 million. Assume the tenant opened for business at the location on June 1, 2016. Assume the tenant is a private company with a calendar year-end and transitioned to ASC 842 on January 1, 2022. Assume the discount rate implicit in the lease is unknown and the tenant’s incremental borrowing rate is 6% on September 1, 2016, and 9% on January 1, 2022.

Here are the steps to take to correctly transition the above lease from ASC 840 to ASC 842 accounting:

Step 1: Determine the lease term under ASC 840

The lease term stated in the contract is 120 months. The document also grants the tenant an early access period, subject to all the terms and conditions in the lease. Assuming the early access period started on February 1, 2016 – 60 days before the April 1 commencement date – then under ASC 840 the lease is accounted for beginning on that date, and the lease term is 122 months: from February 1, 2016, through March 31, 2026.

Note: To understand the difference between the commencement date, execution date, possession dates, etc, read this article on when a lease starts .

Step 2: Determine the total lease payments under GAAP

The tenant will begin paying rent on September 1, 2016 (3 months from the date the tenant opened for business). The total lease payments are $26,863,751, as illustrated in the payment schedule below.

Step 3: Prepare the straight-line amortization schedule under ASC 840

Under ASC 840, the lease term is 122 months (from step 1) and total rent is $26,863,751 (from step 2). Straight-line monthly rent expense calculated from base rent is therefore $220,195 ($26,863,751 divided by 122 months).

The tenant must also account for the total incentive of $1,230,000 ($1.2 million of tenant improvement allowances + $30,000 of moving expenses). Under ASC 840, the incentives are amortized over the lease term on a straight-line basis as well, resulting in a monthly credit to rent expense of $10,082 ($1,230,000 / 122 months). As a result of the incentive adjustment, periodic rent expense on the income statement is $210,113 ($220,195 – $10,082).

Below is the first 16 months’ straight-line amortization schedule under ASC 840, showing amortization of both rent and the incentives.

How is the rent-free period shown on the amortization schedule

The rent-free period is shown on the amortization table as seven months of no payment with the periodic straight-line expense accruing as deferred rent . Below is a summary of the columns in the amortization table impacted by the free rent:

• Cash Payment: This is the exact amount paid out each month.
• Expense: This is the periodic rent expense calculated from the total payment amount divided evenly over the number of months in the lease term, also known as straight-line rent expense.
• Deferred Rent: This is the difference between the expense incurred and the cash paid. In the first seven months, the company has free rent so the deferred rent amount is the total of the expense for the month.
• Deferred Rent Balance: This is the cumulative difference between the expense incurred and the cash paid. When the expense is greater than the payment the balance increases and when the expense is less than the payment the balance decreases until it is $0 at the end of the lease term.

Step 4: On the ASC 842 effective date, determine the total payments remaining

For calendar-year private companies, the effective date of ASC 842 was January 1, 2022. The transition entry is recorded from either the start of the earliest comparative period presented or if companies utilize the practical expedient and do not present comparative financial statements, the transition date.

Most private companies will elect to use the practical expedient to not present comparative financial statements, so our example will as well. Therefore, the transition date for this company is January 1, 2022. The total remaining payments from January 1, 2022, through March 31, 2026, are $12,852,672, shown in the updated payment schedule below.

Step 5: Calculate the operating lease liability

Since the company elected to not present comparative financials, they must calculate the present value of the remaining lease payments as of their transition date. ASC 842 requires private entities to use the rate inherent in the lease, unless that rate is not readily determinable. If the implicit rate is not determinable, the tenant has the option to use their incremental borrowing rate or a risk-free rate .

In this example, the tenant uses their January 2022 incremental borrowing rate of 9%, and payments are made at the end of the month. Using these facts and LeaseQuery’s present value calculator tool , the present value of the remaining lease payments is $10,604,260 . This is the lease liability as of January 1, 2022.

Note: The present value amount above ($10,604,260) is a simplified calculation based on Excel. The number you get should be lower than this, if you were using more accurate interest calculations, like those available in some lease accounting software solutions. Keep this in mind as you’re viewing demonstrations of lease accounting software from your choice of vendors.

Step 6: Calculate the right-of-use asset (with journal entry)

Per ASC 842, the ROU asset is the liability calculated in step 5 above, adjusted by deferred or prepaid rent and lease incentives . In this example, it is the liability of $10,604,260 plus the deferred rent balance as of December 2021, plus the unamortized incentive balance as of December 2021.

Below is a portion of the table from step 3 for the September 2021 through March 2022 periods to show how we arrive at the deferred rent balance and unamortized incentive balance as of December 31, 2021:

The formula for the ROU asset is the lease liability of $10,604,260 less $1,622,743 (accumulated deferred rent balance as of December 2021) less $514,180 (unamortized incentives as of December 2021). This gives us a total ROU asset of $8,467,336 . The journal entry to record the lease liability and ROU asset at transition clears the outstanding deferred rent and lease incentive amounts to the ROU asset and would look like this:

After recording the ROU asset and lease liability as of transition, the tenant would prepare an amortization table under ASC 842 to assist with the calculation of the periodic entries moving forward. Below is the amortization schedule for the lease in the example as of the transition date for a private company.

This concludes the example of how to transition an operating lease from ASC 840 to ASC 842.

How HoganTaylor Can Help

HoganTaylor Lease Accounting Thought Leadership is designed to help you keep up with the latest lease accounting issues that can affect your organization and its compliance. If you have any questions about the content of this publication, or if you would like more information about partnering   with HoganTaylor Lease Accounting , please contact one of our experts.

INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.

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Is right-of-use (rou) asset a fixed asset.

• Updated: November 17, 2023

Table of Contents

Right-of-use (ROU) assets may be loosely defined as fixed assets because they are often treated similarly to property, plant, and equipment (PP&E), especially for finance leases ROU assets.

However, it is not incorrect to define the right-of-use (ROU) asset as intangible, as it represents the lessee’s right to operate an underlying asset. While the underlying asset is usually tangible, the right itself is intangible. In fact, according to GASB 87 (Governmental Accounting Standards Board), right-of-use (ROU) assets are intangible assets, which presents a solid argument for this discussion.

Here is the correct answer:  it is more appropriate to   classify right-of-use (ROU) assets as long-lived assets or non-current assets , which may include both tangible and intangible assets. A broader term like long-lived assets or non-current assets is always the safe answer.

In addition, US GAAP never formalized the term “Fixed Assets” even though it is used interchangeably with long-lived assets such as property, plant, and equipment. Therefore, the answer to the question “Is a right-of-use (ROU) asset a fixed asset?” won’t be a straightforward yes or no.

To help provide some ideas, we also presented a few examples in the section below of how major companies have grouped their ROU assets. (Spoiler: Finance leases ROU assets are often grouped with property, plant, and equipment – the typical fixed assets. While Operating lease ROU assets often have their own category under non-current assets.)

Related reading:

ASC 842 Journal Entries – Direct Financing Lease (Lessor)

ASC 842 Journal Entries – Sales-type Lease (Lessor)

ASC 842 Journal Entries – Operating Lease (Lessee and Lessor)

ASC 842 Journal Entries – Finance Lease (Lessee)

Month-To-Month Lease Under ASC 842

Right-of-use (ROU) assets in simple words

The right-of-use (ROU) asset is like a permission slip, where the lessee has been granted the right to use an asset, such as a car or equipment, for a certain period defined by the lease term (12 months, 24 months, etc.)

With the adoption of ASC 842, both operating and finance leases must present an asset and a liability on the balance sheet. The justification is that the lessee has now possessed an underlying asset, a resource that will generate returns in the future. In this article , we explained that those are the typical characteristics of an asset .

Similarities between right-of-use (ROU) assets and fixed assets

To present this comparison, let’s loosely define fixed assets as “property, plant, and equipment” (PP&E)

• Fixed assets carry the assumption that the benefits-providing period is long-term, or most likely more than 12 months.
• ROU assets share the same characteristics because the typical lease term is over 12 months. For short-term leases or those with a term shorter than 12 months, US GAAP allows them to be directly expensed instead of capitalized.
• Fixed assets typically record depreciation expenses on a straight-line basis.
• For finance leases, ROU assets are also amortized on a straight-line basis. The amortization expense is often grouped with the depreciation of fixed assets.
• For operating leases, ROU assets have a slightly different approach. Each month, the “amortization” expense is the difference between the lease payment and the interest expense. In addition, ASC 842 classifies the expense as an operating expense rather than depreciation, though the concept is the same as this expense is a reduction to the right-of-use asset balance.
• ROU assets are subject to the treatment of impairment guidelines listed in  ASC 360-10: property, plant, and equipment . In other words, when a triggering event occurs, ROU assets must be assessed; a recoverability test must be performed, just like how typical fixed assets are evaluated for impairment.

As a result, companies treat ROU assets very similarly to how they would treat typical fixed assets.

Real examples: Right-of-use (ROU) assets on the Balance Sheet

We looked into how the major companies have classified their right-of-use (ROU) assets on the balance sheet . The result will help us determine if referring to ROU assets as fixed assets is appropriate.

We reviewed Amazon’s 10-k (Annual Report) for the fiscal year ending December 31, 2022, and observed the following.

• In FN1, Amazon clearly stated that assets acquired under finance leases are recorded in the line “Property, plant, and equipment, net,” while all other leases are classified as operating leases.

• We then reviewed the presentation of the ROU assets on its balance sheet. We noted the “operating leases ROU assets” have their own line beneath “Property and equipment, net,” which indicates their non-current nature. We also assume the finance leases ROU assets are grouped with “Property and equipment, net,” given the disclosure in FN1 cited above.
• In conclusion, Amazon grouped their finance lease ROU assets with property, plant, and equipment (PP&E), known colloquially as fixed assets. However, the operating lease ROU assets have their separate line and categorizations.

We also reviewed Apple’s 10-K for the fiscal year ended September 24, 2022, and had the following observations:

• Apple straightforwardly disclosed in FN6 how they grouped their ROU assets.
• Operating leases ROU assets appear on the “other non-current assets” line, while finance leases ROU assets are grouped with “property, plant and equipment, net,” the typical fixed assets.

Lastly, we reviewed Microsoft’s 10-k for the June 30, 2023 fiscal year.

• Just like Apple, Microsoft disclosed in their FN1 how they grouped their ROU assets.
• Operating lease right-of-use (ROU) assets have their own separate line on the balance sheet, while finance lease right-of-use (ROU) assets are included in property and equipment, the typical fixed assets.

The answer is very obvious now. Major companies often treat finance leases right-of-use (ROU) assets as part of property, plant, and equipment, which is widely referred to as fixed assets. On the other hand, operating leases right-of-use (ROU) assets often have their own separate line under non-current assets on the balance sheet.

Suppose you are familiar with the nuance between finance and capital leases. In that case, the way they are categorized on the balance sheet is consistent with their nature: finance leases have a stronger sense of ownership than operating leases, whereas the latter feel more like renting.

What Is a Lease Accountant and What Do They Do?

Key takeaways

• Right-of-use (ROU) assets may be loosely defined as fixed assets, especially for finance leases ROU assets. However, it is not a perfect analog because the argument exists that the “Right” to use assets is intangible.
• Major companies often group finance leases ROU assets with fixed assets. Operating leases ROU assets often have their separate line under the non-current assets.
• It is more appropriate to classify right-of-use (ROU) assets as long-lived assets or non-current assets instead of referring to them as fixed assets.
• Tags: ASC 842 , Finance Lease , Lease Accounting , Operating Lease , ROU Asset

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How to Calculate ROU Asset Balance for an Operating Lease under ASC 842

Accurate ROU balance-sheet calculations are crucial for lease-accounting compliance. Use the information in this article to nail it!

The impact of ASC 842 on ROU calculation  

The release of ASC 842 impacted both the balance sheets and income statements for companies regarding their leases. Under the old standard, companies could configure agreements so that leases were presented in a favorable way, even if the underlying economics of the transaction might have told a different story.  

One of the balance-sheet items that must be recorded is the right-of-use (ROU) asset. The ROU asset represents a lessee’s right to use an asset over the life of the lease. 

Key Takeaways: 

• The three approaches to calculating lease liabilities are: Approach #1 (summing the principal to be paid over the upcoming 12 months); Approach #2 (using the lease liability’s effective interest rate to separately calculate the present value of the lease liability as the long-term portion, and for the short-term portion calculate the present value of the upcoming 12-month payments); and Approach #3 (summing the undiscounted payments that are due in the upcoming 12 months)
• Netgain has chosen to use Approach #1 as it most closely resembles the guidance for the presentation of the current portion of long-term debt
• The short-term portion of the lease liability is calculated by summing the principal to be paid over the upcoming 12 months. The remaining amount is the long-term portion of the liability

Why did this change come about?

Under ASC 840, some companies structured agreements so that all payments would be expensed in the period paid, and no liability would be presented on the balance sheet. Regulators took note of companies that took advantage of this loophole and investigated further. These agreements smelled a lot more like liabilities that should be presented on the balance sheet, and, thus, ASC 842 was born. 

Under ASC 842, a contract is a lease “…if the contract 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…”

If a contract meets this definition, two balance-sheet impacts will be made: an asset and a liability. Depending on the terms of the lease, the lease may be classified as an operating lease or a financing lease. These two classifications have some accounting differences, so the classification is important. The remainder of this article will discuss the asset piece and how it is calculated for operating-type leases. 

How to calculate the ROU asset  

When calculating the ROU asset amount to be booked to the balance sheet, there are several inputs. The overall idea here is that we’re taking the net present value of the payments and booking the ROU asset based on that amount. The incremental borrowing rate of the company is broadly used and is accepted as the discount rate in the Net Present Value (NPV) calculation. There are a few inputs that should also be considered when performing this calculation. These include prepayments, initial direct costs and lease incentives. 

Download Netgain’s free NPV calculator to follow along below with the example below.

Let’s go through a simple example of a lease and the calculation of the ROU asset. We will assume the following terms of the lease and that payment is made in arrears: 

• 60-month term 
• $1,000 payment made monthly 
• 4.5% incremental borrowing rate 

Below, you can see the first 3 months of the schedule based on these inputs. The NPV equation used is as follows with “r” as the monthly incremental borrowing rate: 

NPV = (1st Payment / r ^ Period #) + (2nd Payment / r ^ Period #) + … + (Last Payment / r ^ Period #)  

Once this ROU asset has been booked, it will be amortized over the term of the lease. There will be the corresponding lease liability as well, and these impacts can be major for companies moving to ASC 842. 

Automate amortizations instead  

When considering how to handle this transition, a lot of companies have built a spreadsheet for each lease to track the amortization schedule. With all these inputs—not to mention modifications of leases—using a separate schedule for each lease quickly becomes burdensome and error-prone. That’s when using a tool such as NetLease can save a lot of time and energy and bring immediate compliance. 

Bottom line:  

The calculation of these balance-sheet amounts is at the heart of the lease-accounting standard. Getting this right is critical to being compliant. Unfortunately, this has added some complexity. Use the information above to nail it! 

Lean more about NetLease or request a demo .

What Is ASC 842 Simplified? 

The ASC 842 standard for GAAP lease accounting requires all leases longer than 12 months to be recorded as assets and liabilities on balance sheets. This new standard was developed by the Financial Accounting Standards Board (FASB) to promote more openness between investors and businesses.

ASC 840, the previous GAAP lease accounting standard, has been replaced by ASC 842, which prevents some leases from being categorized as "operating leases" and from being capitalized on the balance sheet. They were consequently left out of numerous financial analysis ratios, such as return on assets, and these omissions could misrepresent a company's performance to an investor.

All firms that adhere to generally accepted accounting rules, or GAAP, are now required to classify every lease as both a liability and a right-of-use asset under ASC 842.

What is the difference between ROU asset and lease liability? 

ASC 842 and IFRS 16 both include the right-of-use (ROU) asset as a crucial part of their current lease accounting standards. The ROU asset is a lessee's entitlement to make use of a leased asset during the period of the lease.

Typically, the leased assets in question are pieces of furniture or machinery. Yet, anything for which a lessee is given permission to use an asset controlled by another organization in order to benefit financially qualifies as a ROU asset.

In simpler terms, an ROU asset is a lease asset. A lease liability is the lessee's discounted financial responsibility to make the payments outlined in the lease agreement.

What is an operating right-of-use asset?

A lessee's right to use a leased asset, usually property or equipment, for the duration of the agreed-upon lease period is known as a right-of-use asset, or ROU asset. In other words, the lessee is given the authority to reap financial rewards from the use of a resource that belongs to another party. This asset is referred to as the "lease asset" in accordance with GASB 87.

According to all three standards (ASC 842, IFRS 16, and GASB 87), a lease liability is the financial obligation to make lease payments that is calculated on a discounted basis.

Where does the operating lease right-of-use asset go on the balance sheet? 

When the Federal Accounting Standards Board published ASC Topic 842, Leases, in 2016, operating lease accounting changed. The new standard offered guidelines when it came to accounting for leases, requiring that the lease and its associated asset value be shown on the balance sheet. Nonetheless, the straight-line basis technique can be used to account for leases that are shorter than a year in length as an expense.

When a lease of greater than 12 months is started, the lessee must record it on the balance sheet as both a lease liability and a right-of-use asset. The goal of the modification is to make a more accurate portrayal of a company's rights and responsibilities and to make it harder for companies to manipulate the balance sheet.

Does ASC 842 apply to operating leases? 

The simple answer is, yes, ASC 842 applies to both finance and operating leases.

Here’s a brief explanation: The recognition of lease assets and lease liabilities on the balance sheet for leases that were classified as operating leases under the prior standards is the main difference between the old and new lease accounting rules. As you surely recall, operating leases were previously considered to be "off balance sheet" transactions. 

Lessees are now required to record all leases with durations longer than 12 months on the balance sheet in accordance with ASC 842. These leases are currently classified as "Operating" or "Finance" leases. Under prior GAAP, finance leases were known as capital leases, but under the current standard, this sort of lease is generally defined the same way.

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