Equipment lease accounting is an important aspect of accounting that involves recording and reporting leased assets in the financial statements. With the implementation of the new lease accounting standard, ASC 842, the accounting for equipment leases has undergone significant changes. In this blog post, we will discuss the key features of equipment lease accounting under ASC 842, its significance, and its impact on financial statements.
Equipment Lease Accounting Under ASC 842
ASC 842 is the new lease accounting standard introduced by the Financial Accounting Standards Board (FASB) that affects companies with leased assets. Under ASC 842, companies are required to recognize most leased assets and liabilities on the balance sheet, thereby enhancing the transparency of lease obligations in the financial statements.
The implementation of ASC 842 requires companies to record a right-of-use asset and a lease liability on their balance sheet. The right-of-use asset represents the lessee’s right to use the leased asset, while the lease liability represents the obligation to make lease payments.
The benefits of the new lease accounting standards include enhanced transparency in financial statements, increased comparability across companies, and better decision-making for stakeholders.
ASC 842 Lease Classification
The lease classification under ASC 842 is determined based on whether the lease transfers ownership of the leased asset to the lessee, whether the lease term is for the major part of the economic life of the leased asset, and whether the present value of lease payments represents substantially all of the fair value of the leased asset.
The lease classification has an impact on the financial statements, particularly the income statement, balance sheet, and cash flow statement. Finance leases result in higher expenses in the income statement, higher assets and liabilities in the balance sheet, and lower cash flows from operating activities in the cash flow statement.
Equipment Lease Journal Entries
Here are the journal entries that a lessee would need to make under ASC 842:
Recording a new lease:
Debit – Right-of-use (ROU) asset
Credit – Lease liability
Payment of lease:
Debit – Lease liability
Credit – Cash
Amortization of the ROU asset:
Debit – Depreciation expense
Credit – ROU asset
Accrued interest on lease liability:
Debit – Interest expense
Credit – Interest payable
If there is a change in the lease terms, such as an extension or a change in the payment amount, then the lessee would need to re-measure the lease liability and the ROU asset. The entry would be as follows:
Debit – Lease liability (difference between new and old lease liability)
Debit/Credit – ROU asset (depending on the nature of the modification)
Credit/Debit – Gain or loss on modification (depending on whether the modification resulted in a gain or loss)
ASC 842 Lease Accounting Examples
Let’s say a company, ABC Corp., has entered into a lease agreement for a piece of office equipment with an annual lease payment of $10,000. The lease agreement has a term of five years/ estimated useful life of 6 years, and there is no option to purchase the equipment at the end of the lease term.
To calculate the lease liability under ASC 842, the company needs to determine the present value of the lease payments. This involves discounting the lease payments to their present value using the company’s incremental borrowing rate (IBR), which is the rate of interest that the company would pay to borrow funds on a collateralized basis over a similar term.
Assuming that the company’s IBR is 5%, the present value of the lease payments would be calculated as follows:
Annual lease payment: $10,000
Discount rate (IBR): 5%
Lease period/term: 5 years
Assets Useful Life: 6 Years
Present value factor (from a present value of an annuity table): 4.4343
Lease liability: $10,000 x 4.4343 = $44,343
ABC Corp. would record a lease liability of $44,343 on its balance sheet at the inception of the lease. The company would also record a right-of-use asset equal to the lease liability, which represents the right to use the equipment for the lease term.
ABC Corp. would record the following journal entry at the inception of the lease:
Dr. Right-of-use Asset $44,343
Cr. Lease Liability $44,343
Over the course of the lease term, ABC Corp. would recognize interest expense on the lease liability using the effective interest method. In this example, assuming the lease liability is not remeasured, the interest expense for the first year of the lease would be calculated as follows:
Lease liability at the beginning of the year: $44,343
Interest expense (5% x $44,343): $2,217.15
Lease payments: $10,000
Reduction in lease liability: $7,782.85 ($10,000 – $2,217.15)
This records the interest expense on the lease liability for the first year of the lease.
At the end of the first year, ABC Corp. would make a lease payment of $10,000. The journal entry to record the lease payment and the reduction in the lease liability would be:
Dr. Lease Liability $7,782.85
Dr. Interest Expense $$2,217.15
Cr. Cash account $10,000
This records the lease payment made, the reduction in the lease liability, and the interest expense recognized for the first year of the lease.
At the end of the first year, the lease liability would be reduced to $36,560.15 ($44,343 – $7,782.85).
The depreciation expense for the first year will be the Right of Use Asset divided by the lease term. In this case, $44,343/5=8659. The entry would be:
Dr. Depreciation Expense $8,868.60
Cr. Accumulated Depreciation $8,868.60
In summary, calculating equipment leases under ASC 842 requires determining the present value of lease payments using the company’s IBR and recognizing a lease liability and right-of-use asset on the balance sheet at the inception of the lease. Over the course of the lease term, interest expense is recognized on the lease liability using the effective interest method, and the lease liability is reduced by lease payments.
Challenges and Opportunities with ASC 842
The implementation of ASC 842 poses several challenges for companies, including identifying and assessing leases, gathering lease data, and updating lease accounting systems. However, the implementation also presents opportunities for companies, such as improved lease management, better decision-making, and enhanced financial reporting.
One of the challenges with ASC 842 is the need to gather lease data for all leases, including those that were not previously recorded. This requires a thorough review of lease contracts and a detailed analysis of lease terms and conditions. Companies need to ensure that they have access to all necessary lease data, including lease payments, lease term, renewal options, and other relevant information.
Another challenge with ASC 842 is the need to update lease accounting systems to ensure compliance with the new standard. Companies may need to invest in new software or upgrade existing systems to accommodate the new lease accounting requirements. This requires careful planning and coordination to ensure a smooth transition to the new standard.
Despite these challenges, the implementation of ASC 842 also presents opportunities for companies. By reassessing their lease portfolio and understanding the impact of lease accounting on financial statements, companies can improve their lease management and make better decisions about lease obligations.
ASC 842 also enhances financial reporting by providing more transparency in lease obligations. By recording leases on the balance sheet, companies provide stakeholders with a clearer picture of their lease obligations, which can help them make more informed decisions.
In conclusion, equipment lease accounting under ASC 842 represents a significant change in lease accounting standards that affects companies with leased assets. The implementation of ASC 842 requires companies to recognize lease liabilities and right-of-use assets on the balance sheet, resulting in enhanced transparency in financial statements. The new lease accounting standard also requires companies to reassess their lease portfolio to determine the lease classification under ASC 842.
While the implementation of ASC 842 poses several challenges for companies, it also presents opportunities for improved lease management and enhanced financial reporting. By following best practices for ASC 842 compliance, companies can effectively navigate the implementation process and ensure compliance with the new lease accounting standard.
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