Deep Dive Blog Series: Part 1 of 5
Hello everyone. I am working on a 5-part blog series for the new ASC 842 Accounting Lease Standards. The 5 parts will be as follows:
- Blog series introduction and new lease accounting terminology
- Basic lease accounting example
- Expanded lease accounting discussion – I
- Expanded lease accounting discussion – II
- Blog series wrap-up & next steps
For some of you, this series will be a solid introduction as you begin the process towards complying with the new ASC 842 standards. For others, this will be a review of information that you have already begun to gather and, hopefully, this series will be a good reinforcement of that information. Without further delay, let’s just jump straight in and do a walk-through of some of the key terminology that will provide you with a solid foundation for the new lease accounting standards and will allow you to explore a handful of lease accounting examples later in this series.
Finance vs Operating Leases
With ASC 842, all leases will be tested using 5 key criteria to determine if it is a finance or operating lease. Finance leases act primarily as the lessee taking ownership of the asset. Operating leases act primarily as the lessee renting the asset for a specific period of time that is less than the assets full useful life. Under IFRS 16, all leases will be classified as finance leases and the test to classify a lease as an operating lease will not be needed.
Right-of-Use Asset (ROU)
This will be how your leased assets will be labeled on your balance sheet. If your assets are categorized as a finance lease, then there will also be an amortization account. If your assets are categorized as an operating lease, then your Right-of-Use Asset (ROU) asset balances will be adjusted instead of being amortized.
Initial Direct Costs (IDCs)
These are direct costs that were incurred exclusively for obtaining the lease. These amounts are included in the calculation of the right-of-use asset dollar amount but are not included in the lease liability since these amounts are paid upfront.
Interest Borrowing Rate
This may not be a new term for equipment leases but it will be new for tracking property leases under the new standards for PVLP calculations for both finance leases and operating leases.
Present Value of Lease Payments (PVLP)
This is the present value of the lease payments calculated using the interest borrowing rate. This present value calculation is used to create the right-of-use asset dollar value. A present value table over the life of the lease will also be used for calculating interest expense and the liability pay down schedule.
New for all property leases and for equipment operating leases, organizations will be required to have a lease liability on the books for all leases. For each year of the lease, the lease liability is equal to the present value of the remaining lease payments.
Payments made to the lessee by the lessor as incentive for signing the lease. Lease incentives received in cash reduce the value of the right-of-use asset.
Residual Value Guaranteed
If this amount is probable, then the residual value guarantee is included in the right-of-use asset and lease liability calculation.
Options that are reasonably certain of being exercised should be included in the value of the right-of-use asset and in the calculation of the present value of the lease payments.
Asset Fair Market Values
The fair market value of the asset at the beginning of the lease is used in determining the classification of a lease as finance or operating. Whereas asset fair market values at the end of the lease can determine if a purchase option for an asset is reasonably certain to be exercised.
At first, the wealth of information on this topic may seem overwhelming but the above list of lease accounting terminology should give you a solid head start. Please also do your own research on the topic as well. Overall, from an accounting and present value stand point, the new standards are very logical to interpret.
Stay tuned for my next blog in the series where I will incorporate the above accounting terms into some lease accounting examples. First, I will begin with a basic lease accounting example to compare the current standards to the new standards. Then I will move on to taking an expanded look on the new lease accounting standards with a few more complex lease accounting examples.
Thank you for reading and be sure to read our other Lease Administration Blogs.
Steven Brenner, CPA
Senior Principal Consultant