Examples of New Operating Lease Treatment

To illustrate the amendments included within Accounting Standards Update 2016-02: Leases, we have developed the following examples. Due to the variety of lease contracts that can exist, these examples are not intended to be all inclusive. Additional examples, however, can be found within Topic 842 of the FASB Accounting Standards Codification.

Example 1

The company has entered into a three-year, non-cancellable lease, with no renewal options.  Annual payments of $200,000 are due, and the company’s incremental borrowing rate is 6%.  The present value of the future lease payments is calculated to be $534,603.Lease-Chart-1

Because the new amendments have not significantly changed the accounting for capital leases (now known as finance leases), we will omit the journal entries from this discussion.  Note, however, that amortization expense associated with the right-of-use asset is calculated on a straight-line basis over the life of the underlying lease contract, and the lease liability is reduced using the effective interest method.  The lessee is required to recognize the amortization expense and interest expense separately within the income statement.

The journal entries that conform to the new guidance related to operating leases are below.

Journal entry at inception:

To capitalize the right-of-use asset and liability that will be carried on the balance sheet.

updated-chart-2
Journal entry at the end of year one:

The first half of the entry represents the actual cash outflow associated with the lease payment, as well as the lease expense recorded in the income statement; this portion of the entry resembles current guidance.  The second half of the entry represents the wind down of the asset and liability recorded at inception.  The decrease in the asset and liability represents the lease expense, less the associated interest.  In this case, the decrease in the asset and liability is the $200,000 lease expense, less the interest associated with that expense of $32,076.  This results in a net decrease to the asset and liability of $167,294.

Lease-Chart-3

Unlike the finance lease, which requires the lessee to recognize amortization expense separately from interest expense within the income statement, the amendments require lessees to recognize expense in the income statement as a single lease cost for operating leases.

 

Example 2

The company has entered into a five-year, non-cancellable lease, with no renewal options.  The company’s incremental borrowing rate is 6%.  Annual payments of $12,000 are paid in arrears, and increase by 5% each year. This results in cash payments of:

Example-2-chart1
Average of the five years of future lease payments is calculated to be $13,261.52.  The present value of the five years of future lease payments is calculated to be $55,546.

example-2-chart-2

Journal entry at inception:

To capitalize the right-of-use asset and liability that will be carried on the balance sheet.

example2chart3
Journal entry at the end of year one:

The first half of the entry represents the actual cash outflow associated with the lease payment, as well as the straight-line lease expense recorded in the income statement; this portion of the entry resembles current guidance. The second half of the entry represents the wind down of the asset and liability.  The decrease in the liability represents the lease expense, less the interest associated.  In this case, the decrease in the liability is the $13,261 straight line lease expense, less the interest associated with that expense of $3,333. The decrease in the asset is the amount necessary to amortize the total lease expense straight line.

example-2-final-chart

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