Understanding lease accounting can be tricky, especially with the introduction of ASC 842. This guide will walk you through a practical example of an operating lease under ASC 842, making the concepts clear and easy to apply. Whether you're an accountant, a business owner, or just someone trying to get a handle on the new lease accounting standards, this article is for you.

What is ASC 842?

ASC 842, Leases, represents a significant change in how companies account for leases. Before ASC 842, operating leases were often kept off the balance sheet, leading to a less transparent view of a company's financial obligations. The new standard requires companies to recognize lease assets and lease liabilities on the balance sheet for most leases, bringing more visibility to these obligations.

Key Changes Introduced by ASC 842:

• Balance Sheet Recognition: Lessees must recognize a right-of-use (ROU) asset and a lease liability for almost all leases.
• Lease Classification: Leases are classified as either finance leases or operating leases, similar to the previous standard, but with some changes in the classification criteria.
• Disclosure Requirements: Increased disclosure requirements provide more information about a company's leasing activities.

Why the Change?

The primary goal of ASC 842 is to provide a more accurate and transparent view of a company's financial leverage and asset utilization. By bringing lease obligations onto the balance sheet, investors and stakeholders can better assess a company's financial health and compare it to other companies.

Operating Lease vs. Finance Lease

Before diving into the example, it's crucial to distinguish between operating and finance leases. Under ASC 842:

• Operating Lease: This is a lease that doesn't transfer substantially all the risks and rewards of ownership to the lessee. Think of it as renting an asset for a specific period.
• Finance Lease: This is a lease that effectively transfers ownership of the asset to the lessee over the lease term. It's similar to buying an asset with financing.

The classification of a lease impacts how it's accounted for, particularly regarding expense recognition and balance sheet presentation. For an operating lease, the lessee recognizes a single lease expense on a straight-line basis over the lease term. For a finance lease, the lessee recognizes amortization of the ROU asset and interest expense on the lease liability separately.

Operating Lease Example: Step-by-Step

Let's walk through a practical example to illustrate how an operating lease is accounted for under ASC 842. We'll cover the initial recognition, subsequent measurement, and financial statement presentation.

Scenario:

• Company ABC enters into a lease agreement for office space.
• Lease Term: 5 years
• Annual Lease Payment: $100,000, payable at the beginning of each year
• Discount Rate: 5% (This is the rate implicit in the lease, or if that's not readily determinable, the lessee's incremental borrowing rate)

Step 1: Initial Recognition

At the commencement date (the date the lease is effective), Company ABC needs to recognize both a right-of-use (ROU) asset and a lease liability on its balance sheet.

Calculate the Lease Liability:

The lease liability is the present value of the remaining lease payments. Since the payments are made at the beginning of each year, we need to calculate the present value of an annuity due.

Using a discount rate of 5%, the present value of $100,000 payable annually for 5 years (annuity due) is:

$PV = PMT × [(1 - (1 + r)^-n) / r] × (1 + r)$

Where:

• $PMT = Annual Payment = $100,000$
• $r = Discount Rate = 5$
• $n = Lease Term = 5 years$

$PV = $100,000 × [(1 - (1 + 0.05)^-5) / 0.05] × (1 + 0.05)$

$PV = $100,000 × [4.3295]

$PV = $432,950

So, the lease liability is $432,950. This represents the present value of all future lease payments, discounted back to today's dollars. It's a critical number because it anchors the accounting treatment for the lease.

Calculate the Right-of-Use (ROU) Asset:

The ROU asset is initially measured at the same amount as the lease liability, plus any initial direct costs incurred by the lessee, less any lease incentives received. In this example, let's assume there are no initial direct costs or lease incentives.

Therefore, the ROU asset is also $432,950.

Initial Journal Entry:

At the commencement date, Company ABC would record the following journal entry:

This entry establishes the asset and liability on the balance sheet, reflecting the company's right to use the office space and its obligation to make lease payments.

Step 2: Subsequent Measurement

After the initial recognition, Company ABC needs to account for the lease over its five-year term. This involves amortizing the ROU asset and reducing the lease liability as payments are made.

Amortization of the ROU Asset:

The ROU asset is amortized over the lease term on a straight-line basis. In this case, the annual amortization expense would be:

$Amortization Expense = ROU Asset / Lease Term$

$Amortization Expense = $432,950 / 5$

$Amortization Expense = $86,590

This expense represents the cost of using the leased asset each year. It's recognized in the income statement and reduces the carrying value of the ROU asset on the balance sheet.

Reduction of the Lease Liability:

Each lease payment reduces the lease liability. Since the payments are made at the beginning of each year, the entire payment reduces the liability.

Journal Entries for Year 1:

1. To record the lease payment at the beginning of Year 1:

   Account	Debit	Credit
   Lease Liability	$100,000
   Cash		$100,000
   To record lease payment

2. To record the amortization expense at the end of Year 1:

   Account	Debit	Credit
   Amortization Expense	$86,590
   Accumulated Amortization		$86,590
   To record amortization

Step 3: Financial Statement Presentation

On the balance sheet, Company ABC will present the ROU asset and the lease liability separately. The ROU asset will be presented among other assets, while the lease liability will be presented among other liabilities. Typically, they'll be categorized as non-current unless a significant portion is due within the next year.

On the income statement, Company ABC will recognize a single lease expense. For an operating lease, this is typically a straight-line expense that combines the amortization of the ROU asset and the interest on the lease liability. In this example, the lease expense for each year is approximately $100,000. This may not be exact due to the way that payments are applied to the liability over time. The goal is to reflect the cost of using the asset over the lease term.

Statement of Cash Flows:

In the statement of cash flows, the lease payments for operating leases are presented within the operating activities section. This reflects the cash outflow related to the lease.

Year-by-Year Breakdown

To further illustrate the accounting, let's look at how the lease liability and ROU asset change over the lease term. Note that this is a simplified example, and in practice, there might be slight differences due to rounding.

Year 1:

• Beginning Lease Liability: $432,950
• Lease Payment: $100,000
• Ending Lease Liability: $332,950
• Amortization Expense: $86,590
• Ending ROU Asset: $346,360

Year 2:

• Beginning Lease Liability: $332,950
• Lease Payment: $100,000
• Ending Lease Liability: $232,950
• Amortization Expense: $86,590
• Ending ROU Asset: $259,770

Year 3:

• Beginning Lease Liability: $232,950
• Lease Payment: $100,000
• Ending Lease Liability: $132,950
• Amortization Expense: $86,590
• Ending ROU Asset: $173,180

Year 4:

• Beginning Lease Liability: $132,950
• Lease Payment: $100,000
• Ending Lease Liability: $32,950
• Amortization Expense: $86,590
• Ending ROU Asset: $86,590

Year 5:

• Beginning Lease Liability: $32,950
• Lease Payment: $32,950
• Ending Lease Liability: $0
• Amortization Expense: $86,590
• Ending ROU Asset: $0

Practical Implications and Considerations

• Discount Rate: The discount rate significantly impacts the lease liability and ROU asset. Choosing an appropriate discount rate is crucial. If the rate implicit in the lease is not readily determinable, use the incremental borrowing rate.
• Lease Term: Determining the lease term can be complex, especially if there are renewal options. Companies need to carefully assess whether renewal options are reasonably certain to be exercised.
• Transition: For companies adopting ASC 842, there are transition requirements that need to be followed. These requirements specify how existing leases should be accounted for under the new standard.
• Documentation: Proper documentation of lease agreements and accounting policies is essential for compliance and audit purposes.

Conclusion

ASC 842 brings significant changes to lease accounting, requiring companies to recognize lease assets and lease liabilities on the balance sheet for operating leases. This example provides a step-by-step guide to accounting for an operating lease under ASC 842, from initial recognition to subsequent measurement and financial statement presentation. By understanding these concepts and applying them correctly, companies can ensure compliance with the new standard and provide a more transparent view of their financial position. Remember to consult with accounting professionals to address specific situations and ensure accurate implementation.