Leases-What You Need to Know About the Changes Part 4: Operating & Finance Lease…

Leases – What You Need to Know About the Changes Part 4: Operating and Finance Lease Examples

By Benjamin R. Ripple, CPA, Partner

In our series of articles, we have covered the accounting for operating and financing leases by a lessee (tenant).  In this article, I thought it would be a good time to illustrate the difference between the accounting for the two with some examples that might make this a little more relatable.

This is a quick example that I put together.  The lease accounting standard update has pages of these in case you want to dive deeper into the differences and some of the special circumstances that might come up.

Facts and circumstances:  Alex Trebek, Inc. (ATI) rents a giant electronic display from Giant Electronics Display, Inc. for use in producing a game show for television.  Under the terms of the lease, ATI pays $10,000 a month over the six-year life of the lease for use of the giant electronic display.  The lease also provides ATI three additional options to extend the lease –  each for an additional three years and at the same rate.  The implicit rate is not determinable from the lease agreement, so ATI will use its incremental borrowing rate of 5% to calculate present value.

Here are some present value charts to help illustrate balances:

Situation A:  ATI does not anticipate exercising any of the renewal options, estimates the useful life of the display at 15 years, and determines that the lease meets the criteria of an operating lease.

At inception, ATI would record the following:

                                                                                                                Debit                     Credit

Right-of-use asset                                                                           $620,928

                Lease liability                                                                                                      $620,928

During year one, the following entries should be recorded:

                                                                                                                Debit                     Credit

Lease expense ($10,000 x 12 months)                                     $120,000

                Cash                                                                                                                      $120,000

Lease liability ($620,928 – $529,907)                                         $ 91,021

Acc. Amort. of ROU asset                                                                                                   $ 91,021

Situation B:  ATI anticipates exercising one renewal option, estimates the useful life of the display at 15 years, and determines that the lease meets the criteria of an operating lease.

At inception, ATI would record the following:

                                                                                                                Debit                     Credit

Right-of-use asset                                                                           $868,261

                Lease liability                                                                                                      $868,261

During year one, the following entries should be recorded:

                                                                                                                Debit                     Credit

Lease expense ($10,000 x 12 months)                                     $120,000

                Cash                                                                                                                      $120,000

Lease liability ($868,261 – $789,894)                                         $ 78,367

Acc. Amort. of ROU asset                                                                                                   $ 78,367

As you can see, there is little difference in the calculation of the lease liability and right-of-use asset, and the journal entries are consistent in Situations A and B.  The main item of note is the vast difference in the value of the liability and asset that exercising the option creates.  The change in assumptions creates almost $250,000 of difference in the initial valuation.

Situation C:  ATI does not anticipate exercising any of the renewal options, estimates the useful life of the display at 7 years, and determines that the lease meets the criteria of a financing lease.

At inception, ATI would record the following:

                                                                                                                 Debit                     Credit

Right-of-use asset                                                                           $620,928

                Lease liability                                                                                                      $620,928

During year one, the following entries should be recorded:

                                                                                                                Debit                     Credit

Lease liability (620,928 – 529,907)                                              $ 91,021

Interest expense (cash paid less liability reduction)                      $ 28,979

                Cash ($10,000 x 12 months)                                                                        $120,000

Amortization expense (620,928 / 6)                                          $103,488

Acc. Amort. of ROU asset                                                                                              $103,488

Situation D:  ATI anticipates exercising one renewal option, estimates the useful life of the display at 10 years, and determines that the lease meets the criteria of a financing lease.

At inception, ATI would record the following:

                                                                                                                Debit                     Credit

Right-of-use asset                                                                           $868,261

                Lease liability                                                                                                      $868,261

During year one, the following entries should be recorded:

                                                                                                                Debit                     Credit

Lease liability ($868,261 – $789,894)                                         $ 78,367

Interest expense (cash paid less liability reduction)                       $ 41,633

                Cash ($10,000 x 12 months)                                                                        $120,000

Amortization expense ($868,261 / 9)                                       $ 96,473

Acc. Amort. of ROU asset                                                                                              $ 96,473

Again, you will notice there is not a lot of difference between Situations C and D except the overall value of the liability.  What you will notice is that there is a significant difference in how the expenses are recorded, and you will note that the overall expenses recorded in C and D are higher than the expenses recorded in A and B.  In comparing Situations A and C, the overall expense recorded is almost $12,500 higher in Situation C.

One positive in looking at the expenses in Situations C and D is that all of the expenses recorded for these financing leases are recorded as interest or amortization expense.  If you have debt covenants tied to EBITDA, all of these financing lease expenses would be excluded from that total.  So, there is one piece of good news.

Hopefully, these examples have helped you gain a little more understanding of the differences between situations and the important part assumptions make in the process.  In our next article on leases, we will look at some specific issues that not-for-profit entities will face under the new lease standard.

Ben Ripple updated

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 […]