A Case Example: Applying ASC 842 New Leasing Standards

As failure to comply can result in fines and penalties, working with your CPA or an accounting and finance consulting firm may be the right path for you. Cohen & Company is not rendering legal, accounting or other professional advice.

• Deferred taxes – The new rules require operating leases to be recorded as right-of-use assets with a corresponding lease liability, consequently grossing up the balance sheet.
• Due to the complexity of the required footnote disclosures, creating a lease accounting spreadsheet is time-consuming and at risk of being inaccurate.
• The new lease standard requires an analysis to be conducted on the components of each lease, which can be time-consuming and tedious.
• An entity must now account for each separate lease component separately from the non-lease components of the contract.
• The true-up would be considered a variable payment and excluded from contract consideration in the calculation of the ROU asset and lease liability.

While many are tempted to delay addressing the new lease accounting standard until the last possible moment, your life will be easier if you learn what to do – and what not to do – sooner rather than later. Simplify your lease accounting implementation by learning from the mistakes of public and international companies that are in their fourth year of following the new lease standard. Payments for penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease. Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee. CAM costs can be set up as a flat fee per month, or can be allocated based on the respective square footage under lease. For instance, it wouldn’t make sense for a small nail salon to pay the same CAM expenses as a large anchor tenant such as a grocery store. Typical CAM costs are maintenance and repairs for parking lots, landscaping, snow removal, cleaning, elevators, hallways and security.

Operating Lease

Costs related to property taxes and insurance do not involve the transfer of a good or service and accordingly are not contract components. As such, these costs do not represent payments for goods and services and are simply part of total consideration. Although these payments may be based on a specific underlying (e.g., real estate taxes), they do not represent components and instead simply reflect another form of consideration under the contract. Such amounts are allocated to their lease and nonlease components following the guidelines described in LG 2.4.2 and LG 2.4.3. Taking this example one step further, let’s assume instead of resetting each year based on actual, the CAM amount is fixed over the entire term of the agreement with the same payments.

• Enter the second practical expedient, which is available to both lessees and lessors!
• Commonly, a nonlease component might be the fee for common area maintenance when renting office space.​ Parking is another nonlease component.
• If elected, the practical expedient will need to be applied to all contracts that qualify for the practical expedient as of the date of the election.
• So, you’ll see leases where maybe it’s a thousand dollars a month, plus any increase in the consumer price index – those kind of things are part of your lease payment.
• Supplier Corp would record the following journal entry on the lease commencement date.

Make preliminary calculations of the lease assets and lease liabilities to determine how financial statements will change. Discuss these results with bankers and bonding agents and the impact on covenants. Liabilities, in general, will increase so working capital and debt to equity ratios will be affected. Deferred taxes – The new rules require operating leases to be recorded as right-of-use assets with a corresponding lease liability, consequently grossing up the balance sheet. Separate lease components and a separate lease component may contain many leases. Non-lease components are distinct elements of a contract that are not related to securing the use of the lease asset.

The Basics of ASC 842, Leases

That being said, outside of the lease liability calculation, these variable expenses should be accrued over the period incurred. If a lessee is required to pay for property taxes and insurance, it does not matter whether the lessee directly pays a third party on the lessor’s behalf or reimburses the lessor. Insurance and property taxes on the underlying asset are not separate lease or non-lease components. The lessee should account for such payments as additional consideration in the arrangement, subject to allocation, and not as insurance or property tax expense. ASC 842 requires the calculation of right-of-use assets and lease liabilities for all lease components.

Commercial real estate managers with retail or office space almost always have CAM costs, and need to be aware of a significant new accounting rule that affects how they are reported. There is one caveat with using comparable market goods and services when it comes to real estate. Per Devon, the values of two identical buildings in different locations will not be the same — the real estate itself is what is driving the value. In 2017, the Governmental Accounting Standards Board issued Statement No. 87.

What do our business owners and financial statement users have to do in response to the new lease accounting standard?

It is expected most companies will take advantage of this expedient because of the resources required to evaluate standalone prices for each component of a lease and to determine a method for allocating consideration to each contract component. For a component to be a lease or nonlease component, some sort of good or service must be transferred to the lessee. Some contracts contain payments that do not contribute directly to the right to use the underlying asset and do not transfer any value to the lessee. State and local taxes – Because the new standard requires ROU assets related to operating leases to be recorded on the same line item as underlying assets, property factors may appear to be increased on a company’s balance sheet. Ultimately, this will affect state apportionment for companies that have activity in states that include property factors when calculating apportionment percentage. The new lease accounting standard is going to significantly change the way that we are accounting for our leases, specifically, our leases of property equipment that are greater than 12 months. We’ll be taking leases and bringing them onto our balance sheet using right-of-use assets and lease liabilities.

New terminology will also replace the old “capital lease” and operating leases will now be brought onto the balance sheet. The company entered into a lease agreement for an office in a large office building. This second amount is basically a monthly prepayment, and at the end of each year, the prepaid amount is compared to the actual costs incurred, and any difference is either paid by the lessee or the lessor issues a credit note. Under ASC 840, some companies included the executory costs while others excluded the amounts from the minimum lease payments thus creating diversity in practice. The annual payments attributable to the lease component are $469,500 ($2,347,500/5).

This practical expedient was offered since companies may not have previously accounted for certain agreements as leases under ASC 840. The underlying asset is so specialized that it is not expected to have an alternative use to the lessor at the end of the lease term. Lease Liability – Liability initially measured at the present value of the lease payments. The lease term is a major part of the remaining economic life of the asset.

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. 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, payments of $2,500 per month or $30,000 per year. 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.

Under the new standard, finance leases and operating leases are measured differently. The lease https://online-accounting.net/ liability represents the present value of all outstanding lease payments that are not yet paid.

• EisnerAmper LLP is a licensed CPA firm that provides attest services, and Eisner Advisory Group LLC and its subsidiary entities provide tax and business consulting services.
• We use Lease Crunch, one of the newest lease-specialized software programs available.
• That is, these arrangements do not need to be capitalized on the balance sheet with a corresponding lease liability and can instead be expensed as incurred on a straight-line basis.
• If you are not a public entity, you can elect the IBR to be the risk-free rate in place at the time of the lease commencement.
• Interest paid to Supplier Corp at the beginning of year 2 would be accrued during year 1 .

If you want to minimize your lease liability and your lease contract includes nonlease components, you have extra work to calculate the breakout between lease and nonlease components. In adopting ASC 842, combining lease and non-lease components will generally result in higher assets and liabilities recorded. However, the combination will reduce the administrative burden of allocating contracts between lease and non-lease components. If elected, careful consideration of the lease payments for both lease and non-lease components should Non-Lease Components Common Area Maintenance be assessed to ensure only the lease payments contemplated in the standard are included, as there is a specific exclusion of most variable payments. So, when it comes to evaluating payments, the calculation primarily focuses on fixed payments known at the time of lease commencement for new leases or adoption of ASC 842 for existing leases. Figure LG 2-4 and Figure LG 2-5 summarize how certain payments are treated in determining contract consideration and allocating it to lease and nonlease components for lessors and lessees.