Last Updated on August 30, 2022 by Neil Patel Accel
Navigating the lease accounting lifecycle is a complex and ever-evolving process. Once an entity has determined a contract is or contains a lease, you will recognize the initial Right-of-use Asset (ROU Asset) and Lease Liability at the Lease Commencement Date. In this blog post, we will dive into how to account for leases at various stages of the lease lifecycle.
Contract Inception Under ASC 842
According to ASC 842, “a contract is, or contains 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 a consideration.”
Prior to the new standards, operating leases were left off the balance sheet. Yet, with the new ASC 842 standards, both private and public companies now need to collect, and evaluate each and every contract to determine if a lease is embedded in the contract terms. Examples of operating leases can span from real estate, cars, airplanes, heavy equipment, and even smaller office items like printing machines, onsite servers or even your coffee machine.
Once your finance team has collected all contracts across the company, then your team will need to determine if an embedded lease exists under ASC 842. There are three requirements for a lease to exist:
- The contract depends on an identified asset
- The customer has the right to obtain substantially all of the economic benefits from use of the PP&E
- The customer has the right to direct the use of the PP&E
Read more on this topic on our blog, How to Identify Embedded Leases.
Lease Commencement Dates
The Lease Commencement date is the date on which a lessor makes an underlying asset available for use by a lessee. Both real estate teams and finance teams have a close eye on the lease commencement date, read our blog Why is the Lease Commencement Date so Important? to gain a better understanding of this critical data point. In essence it kick starts the entire lease accounting lifecycle!
In accordance with ASC 842 guidelines, it is also when the lease classification and the initial measurement commences. That being said, the timing of when lease payments are under contract is not affected by the lease commencement date. Below we are outlining the Five Steps to Complete Initial Lease Measurement at the Lease Commencement Date.
How to Determine The Lease Term
The Lease Term is the noncancellable period for which a lessee has the right to use an underlying asset, together with all of the following:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
- Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor
The lease term begins at the lease commencement date and includes any rent-free periods provided to the lessee by the lessor.
How to Calculate Lease Consideration
At the lease commencement date, the lease payments should consist of the following payments relating to the use of the underlying asset during the lease term:
- Fix Payments: These are payments that may, in form, appear to contain variability but are, in effect, unavoidable. Fixed Payments, include both in substance fixed payments, less any lease incentives paid or payable to the lessee.
- Variable Payments: These payments are dependent on an index or a rate (such as the Consumer Price Index or a market interest rate) initially measured using the index or rate at the lease commencement date.
Check out our glossary of ASC 842 terms to further digest the differences between fixed and variable payments.
How to Determine the Discount Rate
The Discount Rate for the lease initially used to determine the present value of the lease payments for a lessee is calculated on the basis of information available at the lease commencement date or ASC 842 Effective Date, whichever date is later.
The Discount Rate it the rate that yields these to be equal:
How to Perform the Lease Classification Test
The lease classification test is one of the first lease accounting lifecycle processes, and it determines whether a lease is a finance lease or an operating lease. If any of the following are true, then a lessee shall classify a lease as a finance lease at the lease commencement date:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments exceeds substantially all of the fair value of the underlying asset.
- 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.
Read all about the Lease Classification Test and help you determine the accounting treatment of a given lease.
Initial Recognition of Lease ROU Asset & Lease Liability
At the lease commencement date, initial recognition of the lease ROU Asset and the Lease Liability must occur.
- Lease Liability: The initial recognition of the Lease Liability = Present Value of Remaining Lease Payments @ Discount Rate
- ROU Asset: The initial recognition of the ROU Asset is as follows:
+ Initial Lease Liability
+ Prepaid Lease Payments
+ Any Initial Direct Costs
– Any Lease Incentives Received
Subsequent Measurement and Lease Modification Explained
Under the new lease accounting guidelines, ASC 842, both finance and operating lease are measured differently. Within the lease accounting lifecycle, subsequent measurement and lease modification are common.
For finance leases, ROU Asset Amortization and Interest Expense are recorded separately on the income statement. In addition, finance leases will generally have a front-loaded expense recognition.
- The Right of Use (ROU) is amortized on a straight-line basis
- The interest expense is used for the lease liability amortization
- The lease liability is increased by the interest incurred in the period, and the carrying amount is reduced by the lease payment.
For operating leases, a lease expense is recorded in a single financial statement line item on a straight-line basis over the lease term. This differs from a finance lease that includes both amortization and interest expense.
- A single lease cost is calculated so that the remaining cost of the lease is allocated over the remaining lease term on a straight-line basis
- The remaining cost will include the interest charge as well as the ROU Amortization into a single line expense recognized on a straight-line basis
- The straight-line expense is calculated by taking the undiscounted payments and dividing it by the lease term
A lease modification occurs when a change to the terms and conditions of a contract causes a change in the scope of or the consideration of the lease. The following are examples of lease modification that can occur after the lease commencement date:
- A lease extension
- An early termination of the lease
- A change in the timing of lease payments
- Additional lease space added on within the same building
A new contract occurs when an entity shall account for a modification to a contract as a separate contract (separate from the original contract). Only when both of the following conditions are present:
- The modification grants the lessee and additional right of use not included in the original lease. For instance, the right to an additional asset (floor, building, suite, equipment)
- The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract. For example, the standalone price for one floor of an office building (in which the lessee already leases other floors in that building) may differ from the standalone price of a similar floor in a different office building. It was not necessary for the lessor to incur costs that it would have incurred for a new lessee.
Lease modifications are a common event within any given real estate portfolio. In fact, a company with 300 leases will have to track an average of 230 events in a single year as leases are terminated, new leases are signed, and changes occur throughout the lease term. Check out our post on How to Account for Lease Modifications Under ASC 842 to dive deeper into this topic.
Accounting for Leases at Lease Completion
Lease completion closes out the lease accounting lifecycle. If a lease is fully or partially terminated before the expiration of the lease term, there are accounting implications regardless of whether the lease is classified as a finance or an operating lease as denoted below:
When a lease is fully terminated the first step is to de-recognize the ROU Asset and the corresponding Lease Liability. Any difference would be recognized as a gain or loss related to the termination of the lease. Then, if the lessee is required to make any payments or receives any consideration when terminating the lease, it would include such amounts in the determination of the gain or loss.
Full Termination due to Purchase
In this scenario, you, the lessee has purchased the underlying asset from the lessor which terminate the lease contract. The date at which the asset is purchased is when the lessee would establish the fixed asset onto their balance sheet and remove the leased ROU asset.
When a lease is partially terminated, it will be accounted as a lease modification. If the lessee is required to make any payments or receives any consideration when terminating the lease, it would include such amounts in the determination of the gain or loss.
For most real estate and accounting teams this is simply the agreed upon date in which their lease contract ends. In essence, this is when the accounting team would check that their balance sheet accurately reflects their payments for the underlying asset and can then remove the leased ROU asset from the balance sheet.
Financial Statement Recognition and Disclosures
Income Statement Impact
An income statement consists of revenues prior to expenses being removed from the top line. When accounting for finance leases, these expenses are not required to be presented as separate line items. Instead, finance lease expenses should be presented in a manner consistent with how the entity presents other interest expenses and depreciation or amortization of similar assets, respectively. On the other hand, when accounting for operating leases, the lease expense shall be included in the lessee’s income from continuing operations.
Balance Sheet Impact
ROU Assets on the balance sheet are subject to the same considerations as other nonfinancial assets, for instance, property, plant, and equipment. A right-of-use asset recorded for a lease with an initial term of 12 months or less (i.e., the short-term lease measurement and recognition exemption was not taken) may be classified as current similar to other executory contracts. But, generally speaking the ROU Assets should be classified as non-current for the entire lease term.
When accounting for lease liabilities, they are subject to the same considerations as debt instruments in classifying them as current or noncurrent in a classified balance sheet. It is worth noting that, a lessee should either present on the balance sheet or disclose in the notes all of the following:
- Finance lease ROU assets and operating lease ROU assets should be recorded separately from each other and from other assets
- Finance lease liabilities and operating lease liabilities should be recorded separately for each other and from other liabilities
Assessing Materiality for a Lease Portfolio
While ASC 842 does not contain a specific exemption, an entity is not required to apply U.S. GAAP to immaterial items. In other words, materiality is always a consideration in the preparation of financial statements. However, an entity should not simply default to its existing capitalization threshold for PP&E for the following reasons:
- The existing capitalization threshold for PP&E is unlikely to include the effect of the additional asset base introduced by ASC 842. So, the addition of leased assets onto the balance sheet may require a refreshed analysis of the entity’s capitalization thresholds to ensure that the amounts do not become material.
- The existing capitalization threshold for PP&E does not take into account the liability side of the balance sheet. Under ASC 842, if any entity wishes to establish a threshold that avoids accounting for both the ROU Asset and the lease liabilities on the balance sheet, then it must consider the materiality. And the materiality of all its ROU Assets and related lease liabilities that would be excluded with the adoption of such thresholds.
One reasonable approach to developing a capitalization threshold for your lease portfolio is to use the lesser of the following:
- A capitalization threshold for PP&E, including ROU assets
- A recognition threshold for liabilities that considers the effect of lease liabilities.
Materiality is fuzzy area within the lease accounting lifecycle. We dive more into this topic in our blog post, How to Assess Materiality and Recognition Thresholds for a Lease Portfolio.
FX Rate Considerations
Foreign exchange rates are remeasured into an entity’s functional currency when the books are closed each month. Irrespective of lease classification, a lease liability represents a monetary liability and an ROU asset represents a non-monetary asset. With that in mind, an entity’s functional currency would be accounted for in the following manner:
- Lease Liability: Remeasured by using the current-period exchange rate, with changes recognized in net income in a manner consistent with other foreign-currency-demoinated liabilities
- ROU Asset: Remeasured by using the historical exchange rate as of the commencement date, provided that the lease has not been modified.
Lease accounting for Foreign Exchange Rates has become a critical step for International companies to address in their lease accounting processes. Between lease liability and ROU Asset it is tricky to know whether to use the average exchange rate or the historical exchange rate vs actual exchange rate.
The Lease Accounting lifecycle is an intensive and complex process which requires a thorough understanding of ASC 842 and an alignment of teams across departments. We recommend shifting your focus to kickstarting the ASC 842 transition sooner rather than later. It’ll take a steering committee, and organization of all contracts and leases prior to getting down to the nitty gritty complying to the ASC 842 standards.