A Case Example: Applying ASC 842 New Leasing Standards

At a Glance

Main Takeaway

The new ASC 842 leasing standards went into effect for nonpublic entities on January 1, 2022. These changes have shifted how private businesses evaluate leases, the information required for disclosure, and how they present their financial statements.

Although around 98% of private companies have started to transition to these new standards, approximately 33% do not feel prepared to meet the criteria fully.

More challenging aspects of the new ASC 842 standards include policy elections and how those elections change monthly accounting and balance sheet reporting. Correctly accounting for operating leases under ASC 842 can impact your company’s approach from day one, making it vital to understand ASC 842 lessor accounting principles to avoid compliance issues.

Next Step

Read the following ASC 842 operating lease example to better understand how the new ASC 842 standards work to prepare your company for compliant financial reporting.

ASC 842 Operating Lease Example

XYZ Company is an entity in the private sector with a calendar year-end. The company holds a single lease for a commercial office building which was classified as an operating lease in the past. Due to former ASC 840 reporting requirements, XYZ Company typically disclosed future minimum lease payments in its financial statement footnotes. It did not present any lease-related assets or liabilities on its balance sheet.

In this example, assume XYZ Company has decided on the following elections for the lease under ASC 842:

• Elected the cumulative catch-up or modified retrospective adoption approach, having adopted on January 1, 2022
• Elected three expedients which allow it to do the following:
  • Not reassess contracts for embedded existing or expired leases
  • Not reassess the lease classification
  • Not reassess initial direct costs
• Elected to keep the nonlease and lease components separate
• Elected to use the risk-free rate as the discount rate in circumstances where the implicit lease rate is not determinable

XYZ Company’s lease has an original five-year term that began on January 1, 2018. The contract contains a renewal option for an additional two years at the end of the term. As of the adoption date of January 1, 2022, management determined that XYZ Company is likely to renew the lease per the renewal option.

Per the contract terms, XYC Company pays $2,500 per month for the lease. The payment covers the rent of $2,250 per month and $250 in a fixed payment for monthly common area maintenance.

For an efficient transition, the company must determine its remaining lease term. The lease term is a non-cancellable lease period that includes portions covered by an extension option. This extension’s remaining term applies if the lessee is likely to exercise the extension option per ASC 842-10-30-1.

The lease commenced on January 1, 2018, and 36 months of the initial 60-month term have passed. However, since XYZ Company is likely to take the renewal option, it must add a 24-month renewal period to the remaining original term of 24 months. XYZ Company’s remaining operating lease term, therefore, is 48 months on the office building.

Initial Calculation (Day One)

XYZ Company can perform the initial calculation for ASC 842 purposes once it defines the lease term. First, it must calculate the total lease liability by basing it on the present value of future lease payments with the applicable discount rate. In this example, XYZ Company can calculate the lease liability as the present value of 48 months, or 4 years, (remaining lease term) payments of $2,500 per month or $30,000 per year.

XYZ Company includes only the $2,250 monthly payment in the initial calculation. The $2,250 portion that goes towards rent directly relates to the use of the underlying asset, whereas the common area maintenance fee of $250 relates to other goods or services and is a non-lease component.

To arrive at the present value of the remaining lease term, XYZ must figure out the correct discount rate. In this example, the implicit rate in the lease is not determinable. Instead of using an incremental borrowing rate, XYZ elected to use the risk-free rate over the same period.

The risk-free rate is typically based on the U.S. Treasury yield curve rate for an equivalent term. However, the Treasury only publishes rates for 36 months (.97%) and 60 months at (1.26%), so XYZ uses the weighted average of published rates to calculate a 48-month rate of 1.12%.

They can then calculate the lease liability based on the present value of the 48 monthly payments of $2,250 at a discounted rate of 1.12%. You can use Excel to calculate the present value (PV) of future payments.

=PV(rate, nper, pmt, [fv], [type])

The following values apply to the present value formula:

• The annual yield curve rate of 1.12% divided by 12 to determine the monthly rate for the formula
• Nper. The number of payments
• The equal payment amount
• [fv]. The future value. In this example, the value can be left blank
• [type]. The payment type; 1 is an advance payment, and 0 is a payment in arrears

Using its data, XYZ can plug the following numbers into the Excel present value formula:

=PV((1.12%/12),48,-2,250,,1)

The formula results in a lease liability of $105,666.89 as of January 1, 2022.

XYZ can calculate the right-of-use asset after determining the lease liability. This calculation uses the lease liability to start, then adds unamortized initial direct costs and prepaid lease balances. It then subtracts received lease incentives and deferred rent liabilities. For simplicity, this example does not contain any of these items, so the right-of-use asset is the same as the lease liability.

After adopting the new ASC 842 standards, XYZ’s journal entry should look as follows:

Continued Accounting (Day Two)

Two primary transactions that occur each month will affect XYZ’s lease accounting. The first is XYZ’s rent payments on the 1st of the month. The second transaction occurs at the end of the month when XYZ must amortize a month’s portion of the right-of-use asset. The first month after adopting the new standard, these two transactions should be recorded as follow:

XYZ wrote a check to pay rent on January 1, 2022. The transaction only affects cash and lease liability.

The second part of XYZ’s monthly transactions is more complex. The entry for these end-of-month transactions must reflect the accretion of interest on lease liability and amortization of the right-of-use asset.

Unlike a financial lease (formerly, capital lease), entities do not incur interest expenses on their income statement, which means this adjustment is not strictly interest. Instead, the interest reflected is an adjustment for the new present value of remaining payments. Because a month has passed, XYZ must update the old present value calculation to show the passage of time.

In this example, the lease liability on the balance sheet on January 1 was $105,666.89. Also, on January 1, XYZ made a rent payment that lowered the total lease liability by $2,250. This means the interest is based on the left-over lease liability balance during the month of January. To arrive at this number, XYZ takes the original lease liability minus the $2,250 rent payment to get $103,416.89.

With this new lease value, XYZ can then calculate the accretion of interest. XYZ can multiply the monthly interest rate of 1.12% divided by 12 by the lease liability balance to determine “interest” for January.

Interest = (1.12% ÷ 12) x $103,416.89 = $96.52

XYZ must also adjust the right-of-use asset on the balance sheet. This number is the difference between the interest portion of the payment accreted to the lease liability and the straight-line payment. In this example, XYZ can use the following calculation:

Adjustment to right-of-use asset = $2,250 – $96.52 = $2,153.48

XYZ Company’s journal entry on January 31, 2022, should reflect the accretion of the lease liability, record lease expense, and amortize the right-of-use asset:

Going forward, XYZ should have the same set of journal entries each month as long as the payment was made at the same interval.

1. Entry for cash payment made, reducing the lease liability during the first of the month
2. Calculate interest and adjust the lease liability while adjusting the present value and right-of-use asset at the end of the month; the opposite of this entry is recorded as lease expense

Working with an ASC 842 Lease Accounting Partner

While this ASC 842 lease accounting example illustrates accounting processes, it can still be challenging for companies to meet financial reporting compliance criteria. 33% of private entities do not feel ready to transition to ASC 842 on their own, and nearly 93% of private companies face staff shortages that make lease management difficult, effectively being moved down the list of priorities.

Without a dedicated accounting staff or firm, you risk misclassifying elements of your operating lease or making elections early on that adversely affect your accounting down the line.

Many private entities turn to professional accounting firms specializing in ASC 842 leasing to ensure ASC 842 compliance. We provide ASC 842 lease services to help clients transition to these new reporting requirements to maintain compliance with organized accounting practices regarding financial or operating leases.

Benefits of Working with Windes

Our advisory professionals can help you understand ASC 842 changes and where you may need to adjust accounting to stay on top of new regulations.

Your Windes ASC 842 accounting team will provide accounting guidance on balance sheet recognition, lease analysis and classification, and possible accounting treatments. With Windes, you gain peace of mind knowing that we can help you identify and address any gaps between your current lease reporting and what you need to do to bring it up to the new accounting standards.

Our ASC 842 Lease Accounting Services

We offer multiple services regarding ASC 842 lease accounting, including:

• Disclosure requirements
• Expense recognition
• Accounting transition
• Lease classification
• Process implementation
• Policy elections
• Post-issues compliance
• Hosting calculations

Our accounting professionals bring a wide range of experience to benefit your business, including:

• Finance and operating lease analysis
• Accounting policy development process
• Embedded lease review
• Implementation/outsourcing
• Technical training for lessees and lessors
• ROU and lease liability calculations
• Transition and recognition practical expedients
• Sale-leaseback guidance
• IFRS 16 compliance
• Lease component analysis and allocating contract consideration

We use Lease Crunch, one of the newest lease-specialized software programs available. It helps automate required deliverables to improve speed and accuracy for lease reporting.

Stay Compliant with Windes ASC 842 Lease Accounting Services

As a private company lessee, you must keep up with financial reporting requirements regarding your operating and financial leases. Understanding and implementing ASC 842 requirements can be daunting and leave you worried about making an initial election that could lead to permanent differences in your balance sheet or performing an accounting action that snowballs into a significant compliance issue.

ASC 842 lease accounting services from Windes can alleviate some pressure and allow you to focus on other elements of your business. Our experts can answer questions about your company’s implementation of the new standard and its impact. We can also offer potential software solutions to help you track and maintain your organization’s lease information to simplify reporting.

Contact Windes to learn more about our ASC 842 lease accounting services today.