Next Steps of the New Leasing Standard
With the adoption of the new leasing standard (ASC 842), the first step is to identify your lease population, their payment terms, and the lease classifications. After you have identified these, where do you go from here?
Finance and operating leases have different treatments in the financial statements. While both require the capitalization of a right-of-use asset and lease liability, finance leases are treated as being owned by the company, while operating leases are not. For expense purposes, the finance lease right-of use asset is amortized, and interest expense is recognized, whereas for an operating lease, only a lease expense is recorded.
Determining lease classification is only needed on new leases entered into after January 1, 2022 (for private companies with a calendar year end). For leases in existence prior to January 1, 2022, we expect most entities to elect the option of not reevaluating the classification of existing leases. As such, if it was classified as an operating lease under the previous standard (ASC 840), it should continue to be classified as an operating lease. If it was classified as a capital lease under the previous standard, it should be classified as a finance lease going forward.
Initial Recognition in the Financial Statements
Once the lease determination has been made, a right-of-use asset should be capitalized, and a lease liability recognized at the present value of the lease payments on the effective date of the lease. If the lease was already in existence as of January 1, 2022, a transitional journal entry should occur:
- For an operating lease, the right-of-use operating asset and lease liability operating should be recognized at the present value of all remaining lease payments as of January 1, 2022. The rent expense should be reclassified to lease expense.
- For a finance lease, the following accounts should be reclassified: fixed asset to a right-of-use finance asset, accumulated depreciation to accumulated amortization of right-of-use finance asset, capital lease obligation to lease liability finance, and depreciation expense to amortization expense. The interest expense can remain in interest expense.
Entry Under a Finance Lease
Over the life of the lease, the right-of-use asset should be amortized using the straight-line method and the interest expense portion of the lease should be recognized, with the corresponding adjustment to the lease liability.
For example, if a lessee enters into a ten-year finance lease with a 5-year option to extend that is unlikely to be exercised, with lease payments being $50,000 per year, payable at the beginning of the year, initial direct costs of $15,000, and an implicit interest rate of 5.87%, the initial entry to record the lease is as follows:
| Debit Right-of-Use Asset (recorded at present value) | $407,017 | |
| Credit Lease Liability | $342,017 | |
| Credit Cash ($50k lease payment + direct costs) | $65,000 |
The entry to record at the end of the year is as follows:
| Debit Amortization of Right-of-Use Asset | $40,702 | |
| Debit Interest Expense | $20,076 | |
| Credit Accumulated Amortization of Right-of-Use Asset | $40,702 | |
| Credit Lease Liability | $20,076 |
The entry to record once the loan payment is made is:
| Debit Lease Liability | $50,000 | |
| Credit Cash | $50,000 |
Entry Under an Operating Lease
Over the life of the lease, the right-of-use asset will be reduced using the straight-line method and the lease expense will be recognized.
For example, if a lessee enters into a ten-year operating lease with a 5-year option to extend that is unlikely to be exercised, with lease payments being $50,000 per year, payable at the beginning of the year, initial direct costs of $15,000, and an implicit interest rate of 5.87%, the initial entry to record the lease is as follows:
| Debit Right-of-Use Asset (recorded at present value) | $407,017 | |
| Credit Lease Liability | $342,017 | |
| Credit Cash ($50k lease payment + direct costs) | $65,000 |
The entry to record at the end of the year is as follows:
| Debit Lease Expense | $51,500 | |
| Credit Right-of-Use Asset | $31,424 | |
| Credit Lease Liability | $20,076 |
The entry to record once the loan payment is made is:
| Debit Lease Liability | $50,000 | |
| Credit Cash | $50,000 |
Conclusion
As you start recognizing the financial statement impacts of the new leasing standard, it should be noted there are tools available that can help with determining these values. Please contact your current Copeland Buhl representative or me at Nicole_Williams@copelandbuhl.com or (952) 476-7151 if you wish to learn more.