WITH THE NEW ACCOUNTING GUIDANCE going into effect for public companies in 2019 and for all other companies the following year, lessees will need to recognize assets and liabilities on their financial statements for leases with terms longer than 12 months. This is a new development for lessees and one that may prompt questions and concerns that could, if significant, lead to a purchase rather than a lease decision.
Lessors may be justifiably concerned that this accounting change will discourage leasing. One way for lessors to assuage lessees’ concerns is to show them how to calculate the amounts that need to be recorded for a lease using Topic 842 lessee accounting. Under Topic 842, there are two types of leases for lessee classification: finance leases, similar to what are known today as capital leases, and operating leases, the name of which is unchanged. This article sets forth a description of the lessee’s calculations for both finance and operating leases.
Finance Leases
Finance leases are recorded as a right-of-use asset (net of depreciation) and a lease liability. The calculations are similar to the calculations lessors have been using for years.
ROU Asset and ROU Depreciation—Calculation of the right-of-use (ROU) asset begins with the cash rent. The incremental borrowing rate (IBR) is used to calculate a discount factor on each date throughout the term. The rent for each period is multiplied by its respective factor, the sum of which is the present value (PV) of rent. This amount is the initial ROU asset. That same amount is then spread on a level basis over the lease term to create the ROU depreciation. The ROU asset is equal to the initial ROU asset at commencement reduced by each period’s ROU depreciation, as shown in Figure 1.
Lease Liability—The lease liability is calculated by amortizing the rent into principal and interest using the IBR. The principal balance starts at the PV of the rent and drops to $0 at the end of the term. The lease liability at the end of each period is the sum of the principal balance and the accrued interest, less the cash interest, as illustrated in Figure 2.
The Balance Sheet—The ROU asset shown on the balance sheet is obtained by subtracting the ROU depreciation from the initial ROU asset. That amount is added to the cumulative cash (a negative value because rent is an outflow), giving total assets. Over the life of the lease, the value typically starts positive and ends negative at an amount equal to the total rent of the lease. The equity is the total assets less the lease liability, as shown in Figure 3.
The Income Statement—The income statement presents the lease expense. It is calculated by taking the ROU depreciation and adding the interest on the lease liability (calculated using the IBR) and prorated by the number of days in each period.
Operating Leases
Operating leases are somewhat simpler to record. They are recorded as a right-of-use asset and a lease liability.
ROU Asset and Lease Liability—The ROU asset is the lease liability less the deferred rent. The deferred rent is simply the straight-line remaining balance of the total lease payments. The lease liability calculation is the same as for finance leases.
The Balance Sheet—The balance sheet presents the lease transaction such that total assets equals total liabilities and equity. The calculations are as follows:
- Lease Liability – Deferred Rent = ROU Asset
- ROU Asset + Cumulative Cash = Total Assets
- Lease Liability + Equity = Total Liabilities & Equity
The Income Statement—The income statement shows the lease expense, which is calculated on a straight-line basis over the term of the lease, shown as:
- Straight Line Rent Expense = Lease Expense
Four Key Elements
In anticipation of adopting Topic 842, most prospective lessees will be interested in understanding four key elements before making a lease vs. purchase decision. The first two were covered in this article; the third and fourth could be the subject of another article:
- Balance sheet impact, both for assets and liabilities and equity
- Increase/decrease on profitability
- Impact on the statement of cash flows
- Changes to the financial statement footnotes
Be sure to read the latest Lease Accounting Update: FASB Agrees to Amendments to Help Ease Burden of Leases Implementation by John Bober.
