Leases – What You Need to Know About the Changes Part 2: Operating Lease Accounting
By Benjamin R. Ripple, CPA, Partner
Oh, FASB, why must you be so cruel? FASB has left us the term operating lease in the new lease standard as a stinging reminder of the good old days when you were allowed to just disclose in the notes to the financial statements all of those glorious operating leases that remained hidden away off of the balance sheet.
Yes, operating leases under the new standard will be capitalized, but that does not make properly identifying your leases as operating or finance any less important than it was to properly identify a lease as operating or capital under the old standard. The reason it is still important is because the monthly accounting for an operating lease is different from the accounting for a finance lease.
In this article, we will cover step by step the basics for accounting for an operating lease by a lessee (tenant) under the new standard.
The first step in accounting for either an operating or finance lease is determining the amount to capitalize as the right-of-use asset and lease liability. This amount should be the present value of the expected lease payments. The expected lease payments should include payments to be made in optional periods if those periods are reasonably certain to be exercised. The expected lease payments should exclude most variable payments other than those that depend on an index or a rate. A discount rate is used to determine present value of these payments. This rate should be the implicit rate of the lease, unless that rate cannot be easily determined. If that is the case, the discount rate should be the lessee’s incremental borrowing rate. This step is usually the most difficult part of the new lease standard, as there is a fair amount of judgment going into whether or not options will be renewed and what rate should be used to discount to present value.
The second step is accounting for the monthly activity of the lease. For an operating lease, the lease liability should equal the present value of all remaining lease payments using the discount rate established in setting up the liability originally. The only time you would change the interest rate is if there was a re-measurement of the lease due to changes in the terms or resolution of a contingency in the variable payments.
The right-of-use asset in an operating lease should typically equal the lease liability. The exceptions to this would include any prepaid or accrued lease payments, a remaining balance of any lease incentives received, unamortized initial direct costs, or an impairment of the right-of-use asset.
On the expense side, a single lease cost is recognized in the income statement. The expense should generally be recognized on a straight-line basis over the life of the lease.
Assuming you have a lease that does not include any escalating payments, your normal monthly entry for the lease would be debiting the liability and crediting the right-of-use asset for the same amounts to keep them the same, crediting cash for your lease payment and debiting the lease expense as the other side of the entry. So, the only difference from the current method of accounting for an operating lease is the extra step of reducing the asset and liability to reflect the remaining present value of payments.
Finally, when reporting on the cash flows for operating leases, all lease payments should be recognized in the operating section of the statement of cash flows, which is a much simpler treatment than accounting for finance leases.
Following these steps should get you where you need to be on your operating leases. It is not as simple as it used to be, and there will be some issues to get the asset and liability recorded. Overall though, the process will not be too painful if you did a good job of gathering the information about your leases that was described in the first part of this series.
If you have any questions or concerns surrounding the new lease standard, please reach out to your trusted accounting advisors sooner rather than later.
Benjamin R. Ripple Partner, CPA
Ben is a partner in BRC’s assurance services. Since starting his career in 2001, Ben has worked with clients ranging from family-owned companies, to multinational corporations, to not-for-profit and governmental entities requiring A-133 audits. Ben’s industry experience includes: Manufacturing and distribution Hospitality, including restaurants and hotels Investment companies Governmental and not-for-profit entities Affordable housing […]