Last Updated on October 13, 2022 by Morgan Beard
With ASC 842, accounting teams must reflect all operating lease financial information on the company balance sheet. Journal entries are foundational to recording the accounting transactions associated with your lease portfolio. Under ASC 842 operating lease journal entries require recording:
- Right of use (asset)
- Lease (liability)
Finance teams may have found that it’s created more work, such as:
- Creating new processes for managing contracts
- Increasing contact and communications with the asset management and real estate teams
- Increasing the time needed for teams to comprehend and adhere to new reporting requirements
ASC 842 also significantly impacts financial statements and report ratios so understanding ASC 842 journal entries is essential for your accounting team to maintain GAAP compliance.
Operating vs. Financing: What’s the difference between these two lease types?
There are fundamental differences between operating and financing leases.
- Do not present opportunities for lessees to take ownership of the leased asset
- Must be included on the balance sheet of both lessor and lessee
Note: Leasing terms of more than 12 months must be on the balance sheet, but if you have a short-term lease, less than exactly 12 months or less, FASB doesn’t require its inclusion.
Alternatively, financing leases (known as capital leases under the FASB’s ASC 840) became financing leases with the introduction of the Financial Accounting Standard Board’s ASC 842. If there’s a reasonable expectation that a lessee will assume ownership at the culmination of a lease, the lease is deemed a finance lease.
However, US Generally Accepted Accounting Principles (GAAP) provide five conditions regarding finance lease accounting. If your lease meets any of these conditions, it falls under the finance lease umbrella.
The five GAAP criteria for determining if a lease is a finance lease are:
- If the lessee assumes ownership over the asset upon completion of the lease’s terms.
- If the lessee has the right to buy the asset, a purchase option, and is reasonable certain they, the lessee will exercise that right.
- If the lease’s term covers a majority of the economic life or useful life of the identified asset. (Note: This condition does not apply if the lease originates at or close to the end of the asset’s remaining economic life.)
- If today’s value of all payments (plus any remaining value the lessee has promised that’s not yet reflected in payment) is equal to or substantially more significant than the total fair market value of the asset.
- If the asset is so unique (such as software or equipment explicitly built for the lessee), it serves no purpose for the lessor at lease completion.
Accounting for operating leases under the FASB’s ASC 842
By FASB standards, leases must be classified to ensure proper lessee accounting and/or lessor accounting compliance. Under the FASB’s ASC 840, the two lease types were operating and capital. With the introduction of ASC 842, capital leases became finance leases.
Accounting departments with leases deemed as operating under the FASB’s ASC 840 can maintain the operating lease designation at ASC 842 adoption. All leases in the future must follow the FASB’s ASC 842 guidelines.
The greatest difference to understand under the new guidelines is that all leases, operating and finance, must be reflected on your organization’s balance sheet, such as right-of-use assets and lease liabilities. Operating leases must record journal entries under the FASB’s ASC 842 guidelines
Recommended Reading: Comparing ASC 840 to ASC 842: Going From Old to New Lease Accounting Standards
What is the journal entry for an operating lease?
Under ASC 842, journal entries for operating leases are:
- Lease liability. Represented as today’s value of all lease payments remaining on the contract.
- ROU (right-of-use) asset. Your rights to the underlying asset, that you are leasing, which you’ll amortize over the life of the asset. In this case, the useful asset life is the term of the lease contract, typically in months.
It’s essential to understand the calculations required for these journal entries. A lease amortization schedule is foundational to calculating your journal entries under the new standard.
Steps to calculate ASC 842 journal entries
Once you’re familiar with the differences between ASC 840 and ASC 842, you’ll better understand accounting standards for leases going forward. To correctly enter ASC 842 journal entries and ensure your balance sheet figures are correct, there are a few steps to follow. (The figures in the following steps are examples.)
Step 1 – Recognize lease liabilities and ROU assets
Operating lease #123 has initial values on January 1 of:
- Lease liability: $112,000
- ROU asset: $112,000
In turn, your new ASC 842 journal entries to recognize the commencement of this lease will be as follows:
- January 1: Debit of $112,000 under the ROU asset account
- January 1: Credit of $112,000 under the lease liability account
When tallying figures for the balance sheet, the lease liability and ROU asset accounts are now included.
Step 2 – Recognize payments and amortization
Regardless of reporting frequency, you’ll note:
- All payments including any initial direct costs
- Accrued interest on lease liabilities
- ROU asset amortization
Note: This assumes there aren’t any modifications to entries. Modifications are handled separately, as we’ll cover in just a moment.
As most organizations are on a monthly reporting schedule, these ASC 842 journal entries follow monthly reporting. So, January’s journal entries would be as follows:
To reflect the payment made:
- January 1: Lease liability account debited $112,000
- January 1: Cash account credited $112,000
To reflect amortization:
- January 1 – 31: Lease expense debited $10,000
- January 1 – 31: ROU asset credited $10,000
To reflect interest expense:
- January 1 – 31: Lease expense debited $2,000
- January 1 – 31: Lease liability credited $2,000
The payment made on January 1 reduces the overall lease liability by $10,000.
Amortization reduces the ROU value for January.
The interest expense reflects an increase in lease liability value.
Step 3 – Continue recording ASC 842 journal entries until the lease expires
Assuming there are no modifications to your lease agreements, you continue posting entries according to your chosen frequency until the lease expires. Each journal entry results in lease liabilities and ROU assets zeroing out.
Step 4 – Account for modifications
On the date of a modification, you must reassess the value of lease liabilities and ROU assets.
For instance, suppose you learn on July 15 that the current $10,000 payments are increasing to $12,000 on August 1. The discount rate modification is 6%. This requires the creation of a remeasurement journal entry because this change will impact your future cash flow statement in terms of the liability’s present value. The difference between these cash paid amounts in the remeasurement journal entry is reflected in the following calculation:
- Lease liability before modification: $102,000
- Lease liability after modification: $115,000
- Movement: $13,000
So, July’s journal entries would be as follows:
To reflect July’s payment:
- July 1: Lease liability debited $102,000
- July 1: Cash account credited $102,000
To reflect the upcoming modification:
- July 15: ROU asset debited $13,000
- July 15: Lease liability credited $13,000
To reflect amortization:
- July 1 – 31: Lease expense debited $60,000
- July 1 – 31: ROU asset credited $60,000
To reflect interest expense:
- July 1 – 31: Lease expense debited $690
- July 1 – 31: Lease liability credited $690
August’s entries would reflect the new modified payment schedule:
- August 1: Lease liability debited $115,000
- August 1: Cash account credited $115,000
Your remaining journal entries will continue with the logic applied in prior months when reporting.
Also, note that these entries exhibit changes when scope increases — it’s a relatively straightforward process. If there had been a decrease in scope, your entries wouldn’t follow the same logic as the initial measurement. There are further steps to account for a scope decrease. For instance, an example of a scope decrease would be a lessee negotiating a material change to the lease, such as opting to lease out two office spaces instead of five.
FASB ASC 842 journal entries: Transitioning from FASB ASC 840
So, what do journal entries look like when making the initial transition from 840 to 842 compliance?
If your accounting method accounts for leases by commencement date, your ASC 842 journal entries should reflect ROU assets and lease liabilities on the transition date. After that, it’s just business as usual using accounting best practices for ASC 842. The effective date for the new standard is December 15, 2021 for a majority of private organizations
If you are a small business, you may be able to handle the new guidance transition in spreadsheet. Accounting for the changes posed by ASC 842 is much easier with lease accounting software. Reach out to our team to learn more or schedule a demo.