ASC 842
Accounting topics surrounding leases can be confusing and hard to grasp when trying to apply the principles. The following is a guide to help you better understand ASC 842 and how to properly account for your leases as the lessee.
ASC 842 is an updated accounting standard that replaced ASC 840. Previously, under ASC 840, leases were categorized as either an operating lease (i.e. real estate, machinery rental) or a capital lease, with operating leases being left off the balance sheet and only having the expense recognized on the income statement. Investors wanted FASB to modify the standards due to the uncertainty of any future lease payment obligations. Under the new standard, FASB states that all leases (regardless of classification) that cover more than 12 months should be recorded and tracked on the balance sheet. This update helps to enhance the transparency of the company’s financials and impact financial analysis rations such as the current ratio. In addition to the balance sheet effect, ASC 842 also modified the financial statement disclosures that must be made to include the value, timing, and any cash flow concerns associated with the lease.
Classifying Leases
Leases can be classified as either operating leases or financing leases. If a lease meets any of the following criteria than it will be classified as a financing lease:
· At the end of the lease, the asset transfers ownership.
· The lessee is probable to exercise a purchase option at termination.
· The underlying asset has no useful life left at end of lease term.
· If the lease term covers 75% or more of the useful life of the underlying asset.
· If the PV of the total lease payments is 90% or more than the fair value of the underlying asset.
Anything that does not qualify as a financing lease is therefore classified as an operating lease.
Operating Lease Journal Entries and Example
We will use the following example to show how the journal entries work under ASC 842. You have a 3-year lease beginning 1/1/2024 and ending 12/31/2026. The first payment is due upon inception. Under the terms of the lease the monthly payments are $5,000 per month with an annual increase every year of 4% and an incremental borrowing rate of 3.17%. (Please see amortization table at the bottom for a visual reference).
To draft the first journal entry, we will need to find the present value of the payments over the life of the lease. At a discount rate of 3.17% the PV of the payments is $178,764.61. This amount represents what the lease is worth at the inception date.
· PV of Lease Payments =FV / (1 + Interest rate for the period) n Period)
Op. Lease - Journal Entry for Inception of Lease
Date | Account | Debit | Credit |
1/1/2024 | Right of Use Asset | 178,764.61 |
|
1/1/2024 | LT Lease Liability | 123,474.22 | |
1/1/2024 | ST Lease Liability |
| 55,290.39 |
· Right of Use Asset – The right of use asset is equal to the PV of the lease payments.
· LT/ST Lease Liability- Split the liability between the long-term and short-term portion of the lease liability. At inception, the combined liability amounts will equal the right of use asset.
Op. Lease - Journal Entry for First Month Payment
Date | Account | Debit | Credit |
1/1/2024 | Operating Expense | 5,000.00 |
|
1/1/2024 | Cash |
| 5,000.00 |
· This entry represents the first month payment upon inception of the lease.
Op. Lease - Journal Entry for First Month End (Adjust Right of Use Asset, LT/ST Lease Liability, and Operating Expense)
Date | Account | Debit | Credit |
1/31/2024 | Operating Expense | 202.66 |
|
1/31/2024 | LT Lease Liability | 4,887.57 |
|
1/31/2024 | ST Lease Liability | 346.59 | |
1/31/2024 | Right of Use Asset |
| 4,743.64 |
· Operating Expense – The total operating expense is uniform month over month for the life of the lease. The operating expense is found by totaling the base lease payments ($187,296) and dividing by the total number of periods (36), which will give us the operating expense for each month ($5,202.66). As such, the operating expense must be adjusted month over month to align. Since we charged $5,000 to operating expense when we made the lease payment at the beginning of the month, we will need to debit the operating expense account an additional $202.66.
o Lease Operating Expense per Month = Total Base Payments / Total number of periods
· LT/ST Lease Liability – Both long-term and short-term liability will be adjusted by their respective change month over month. The total lease liability is decreased by the base payment for the month ($5,000) and increased by the interest that was charged for the month ($459.02) to result in a net decrease of $4,540.98 that will be allocated between the long-term and short-term liabilities.
o Ending Lease Liability = Beg. Lease Liability - Base Payment + Interest Charged on Lease
o Interest Charged on Lease = (Beg. Lease Liability - Base Payment) * (Interest Rate for Period)
· Right of Use Asset – The right of use asset is decreased by the total operating expense for the month ($5,202.66) and then increased by the interest charged for the for the month ($459.02) for a net decrease of $4,743.64.
o Right of Use Asset = Beg. Right of Use Asset – Operating expense + Interest Charged on Lease
When looking at the entry you will also notice that the net change in the lease liability is less than the change in the right of use asset. This difference represents the deferred operating expense that will be adjusted period over period.
Now let’s journal the following month as well:
Op. Lease - Journal Entry for Second Month Payment
Date | Account | Debit | Credit |
2/1/2024 | Operating Expense | 5,000.00 |
|
2/1/2024 | Cash |
| 5,000.00 |
Op. Lease - Journal Entry for Second Month End (Adjust Right of Use Asset, LT/ST Lease Liability, and Operating Expense)
Date | Account | Debit | Credit |
2/29/2024 | Operating Expense | 202.66 |
|
2/29/2024 | LT Lease Liability | 4,900.47 |
|
2/29/2024 | ST Lease Liability | 347.50 | |
2/29/2024 | Right of Use Asset |
| 4,755.63 |
· Operating Expense – Just like last month, we will adjust the operating expense so the total is the same month over month ($5,202.66). Since we charged $5,000 to operating expense when we made the lease payment at the beginning of the month, we will need to debit the operating expense account an additional $202.66.
· LT/ST Lease Liability – Long-term and short-term lease liability will be adjusted by their respective change month over month. The total liability is decreased by the base payment for the month ($5,000) and increased by the interest that was charged for the month ($447.03) to result in a net decrease of $4,552.97 that will be allocated between the long-term and short-term liabilities.
· Right of Use Asset – We will again decrease this by the difference between the monthly operating expense ($5,202.66) and the interest charged this period ($447.03) for a net decrease of $4,755.63.
Financing Lease Journal Entries and Example
Finance leases are accounted for in similar ways with a few distinct differences.
For this example, we will continue to use the facts provided in the example for operating leases.
The initial entry for a financing lease is identical to the one for an operating lease, we will need to determine the present value of all the payments at a discount rate of 3.17%, which is $178,764.61.
· PV of Lease Payments =FV / (1 + Interest rate for the period) n Period)
Fin. Lease - Journal Entry for Inception of Lease
Date | Account | Debit | Credit |
1/1/2024 | Right of Use Asset | 178,764.61 |
|
1/1/2024 | LT Lease Liability | 123,474.22 | |
1/1/2024 | ST Lease Liability |
| 55,290.39 |
· Right of Use Asset - The right of use asset is equal to the PV of the lease payments.
· LT/ST Lease Liability- Split the liability between the long-term and short-term portion of the lease liability. At inception, the combined liability amounts will equal the right of use asset.
Fin. Lease - Journal Entry for First Month Payment
Date | Account | Debit | Credit |
1/1/2024 | Amortization Expense | 5,000.00 |
|
1/1/2024 | Cash |
| 5,000.00 |
· This entry represents the first month payment upon inception of the lease.
Fin. Lease - Journal Entry for First Month End (Adjust Right of Use Asset, LT/ST Lease Liability, Amortization Expense, and Interest Expense)
Date | Account | Debit | Credit |
1/31/2024 | Interest Expense | 459.03 |
|
1/31/2024 | LT Lease Liability | 4,887.56 |
|
1/31/2024 | ST Lease Liability | 346.59 | |
1/31/2024 | Right of Use Asset | 4,965.68 | |
1/31/2024 | Amortization Expense |
| 34.32 |
· Interest Expense – This is the total interest charged on the lease for that period. In this case we will take the total liability balance ($178,764.61), subtract out the base payment for the month ($5,000) and then multiply by the interest rate for the period (0.264167% [3.17% / 12]) to get the interest charged for the month ($459.03).
o Interest Charged on Lease = (Beg. Lease Liability - Base Payment) * (Interest Rate for Period)
· LT/ST Lease Liability – Both long-term and short-term liability will be adjusted by their respective change month over month. The total lease liability is decreased by the base payment for the month ($5,000) and increased by the interest that was charged for the month ($459.02) to result in a net decrease of $4,540.98 that will be allocated between the long-term and short-term liabilities.
o Ending Lease Liability = Beg. Lease Liability - Base Payment + Interest Charged on Lease
· Right of Use Asset – The right of use asset will decrease via straight line amortization. This is equal to the total PV of lease payments ($178,764.61) divided by the total lease periods (36) to determine the monthly amortization ($4,965.68).
o Financing Lease Amortization = Total PV of Lease Payment / Periods of Lease
· Amortization Expense – The amortization expense will be uniform across the entire life of the lease. The monthly amount will equal the decrease in the right of use asset. In the entry to make the rent payment at the beginning of the month we charged amortization of $5,000 so we will need to credit amortization expense by $34.32 to equal the decrease in the right of use asset ($4,965.68).
Fin. Lease - Journal Entry for Second Month Payment
Date | Account | Debit | Credit |
2/1/2024 | Amortization Expense | 5,000.00 |
|
2/1/2024 | Cash |
| 5,000.00 |
Fin. Lease - Journal Entry for Second Month End (Adjust Right of Use Asset, LT/ST Lease Liability, Amortization Expense, and Interest Expense)
Date | Account | Debit | Credit |
2/29/2024 | Interest Expense | 447.03 |
|
2/29/2024 | LT Lease Liability | 4,900.47 |
|
2/29/2024 | ST Lease Liability | 347.50 | |
2/29/2024 | Right of Use Asset | 4,965.68 | |
2/29/2024 | Amortization Expense |
| 34.32 |
· Interest Expense – This is the total interest charged on the lease for that period. In this case we will take the total liability balance ($174,223.63), subtract out the base payment for the month ($5,000) and then multiply by the interest rate for the period (0.264167% [3.17% / 12]) to get the interest charged for the month ($447.03).
· LT/ST Lease Liability – Long-term and short-term lease liability will be adjusted by their respective change month over month. The total liability is decreased by the base payment for the month ($5,000) and increased by the interest that was charged for the month ($447.03) to result in a net decrease of $4,552.97 that will be allocated between the long-term and short-term liabilities.
· Right of Use Asset – The right of use asset will decrease via straight-line amortization. This is equal to the total PV of lease payments ($178,764.61) divided by the total lease periods (36) to determine the monthly amortization ($4,965.68).
· Amortization Expense – The amortization expense will be uniform across the entire life of the lease. The monthly amount will equal the decrease in the right of use asset. In the entry to make the rent payment at the beginning of the month we charged amortization of $5,000 so we will need to credit amortization expense by $34.32 to equal the decrease in the right of use asset ($4,965.03).
Additional Accounting for Incentives, Fees, Reimbursements and Triple Net Leases.
Many times, leases will include stipulations or incentives that will need to be accounted for. For instance, if there is an incentive in which the first month of rent is free, then the PV calculations for the right of use asset and lease liability will need to take that into account. Any additional fees that are charged on the lease will also be included in the calculation. In the case of triple net leases (leases where the tenant covers expenses such as insurance, maintenance and taxes), the estimated monthly fees will be included in the PV calculations as well. Landlords will sometimes include an allowance for leasehold improvements (tenant improvement allowance). If the allowance is paid prior to the beginning of the lease, it will decrease the opening balance of the asset, however if it is payable after the lease starts or in instalments, it will reduce the payments for the respective periods in the lease calculation.
ASC 842 also requires any executory costs (i.e. property taxes, maintenance) to be included in the lease calculation. In addition, lessees must identify lease and non-lease components. Lease components are anything that is related to the underlying asset while the non-lease component is for goods/services that are distinct from the leased asset. Though, companies may elect a practical expedient in order to evaluate all the costs together.
Operating Lease Amortization Table
Financing Lease Amortization Table
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