Updates to Accounting for Operating Leases

lease-agreement.jpgIn 2016, the Financial Accounting Standards Board (FASB) released Accounting Standards Update (ASU) 2016-02: Leases. This update presents an approach fundamentally different to how operating leases are currently being recorded – that operating leases will now be brought onto the balance sheet. The update is effective for non-public companies with fiscal years beginning after December 15, 2019 (i.e. – effective for 2020 calendar year-ends and 2021 fiscal year-ends). We would like to highlight what businesses can expect from the new standard.

Initial recording:
Upon the commencement date per the lease agreement, the lessee records an underlying right-of-use asset on their balance sheet as well as a liability representing what they will be obligated to pay the lessor over the life of the lease agreement. The amounts for the asset and liability will be recorded on day one at the same amount. The calculation of the initial amounts is simply the contractual payments to be made per the lease agreement discounted back to present value based on the lessee’s incremental borrowing rate. To arrive at the discounted present value amount, businesses need to go back to consult the “present value tables” (similar to their accounting and finance courses in college) or use a financial calculator.

Recording the lease payments:
Next, as payments are being made over the life of the lease pursuant to the agreement these amounts are expensed through the income statement in the amount paid (*). Also of note is that the asset and liability need to both be reduced down to zero over the life of the lease. You can almost think of this similarly to a note payable amortization schedule. The opening balance of the asset/liability times the rate mentioned above will yield current year asset/liability reduction amount (**). It is important to note that the present portion of the lease liability needs to be classified in current liabilities at the end of each year, with the remainder of the liability in long-term. Let us throw a few numbers in here to bring this all to life.

The accounting entries corresponding to the year-one lease payment would look something along these lines.

 

  DR CR
Lease expense (*) $10,000  
Cash (*)   $10,000
Liability (**) $8,626  
Asset (**)   $8,626

 

At the end of the lease life the business has paid out the entirety of the $50,000 pursuant to the terms of the operating lease, and the asset and liability at discounted present value have both been reduced to zero.

Effect on covenants:
An important impact that business can expect from the new treatment of operating leases is its effect on debt covenants – namely the balance sheet-based ratios like the current ratio. This is due to the fact that while the right-of-use asset is classified solely in the noncurrent section of the balance sheet under property and equipment, the current portion of the lease liability is broken out from the rest and shown under current liabilities. Businesses may want to analyze what effect (if any) the new lease standard will have on their covenants and potentially have a discussion with their lender about modifying them.

Contact Us With Your Questions:
If you have questions about Operating Leases or other accounting issues, contact our accounting professionals at The Innovative CPA Group at 203-489-0612. Or contact us online.