Accounting for Leases: Accounting Standards Codification (“ASC”) 842: Overview of Capital (Financing) Leases under ASC 842
Main changes from prior lease standard
Under ASC 842, capital leases will now be called “financing” leases. Furthermore, the criterion for consideration of the lease classification has changed slightly to add more management judgment, as well as adding one more criterion:
- Ownership transfers at the end of the lease
- Note: The asset will be owned by the company after the lease term
- The lease contains a purchase option that will reasonably be exercised
- Note: Change from the need for a “bargain” purchase option
- The lease term is a major part of the remaining economic life of the asset
- Note: “Major part” is not defined as a specific percentage
- The present value of the lease payments is substantially all the fair value of the asset
- Note: “Substantially all” is not defined as a specific percentage
- The asset is specialized with no alternative use to the lessor
- Note: new under ASC 842
Financial Statement impact:
Balance Sheet: There will be a financing lease right-of-use asset and an associated financing lease liability. The liability must be classified between current and non-current.
Income Statement: There will be two expenses included in the income statement related to financing leases. The first is the interest expense related to the lease liability which will be calculated using the effective interest rate method. The second is the amortization expense for the right-of-use asset which is calculated on a straight-line basis.
Cash Flow Statement: Principal repayments of the lease will be classified within financing activities, while the interest on the lease liability will be classified within operating activities.
Initial Measurement:
(Note: Same calculation as an operating lease liability and operating lease right-of-use asset)
To determine the initial measurement of the financing lease liability, the present value of the lease payments not yet made needs to be calculated. The rate that will be used to calculate the present value will be either of the following:
- The rate implicit in the lease (to be used if this is determinable)
- Lessee’s incremental borrowing rate (the rate at which lessee could borrow a similar amount for a similar term)
Nonpublic companies can make an election to instead use the risk-free rate instead of the incremental borrowing rate. However, once elected, the company must follow this election going forward. Furthermore, this will create a slightly higher lease liability compared to using the incremental borrowing rate. Nonpublic companies must decide between spending the time to find the incremental borrowing rate for all leases, or a higher lease liability by using the risk-free rate.
The financing lease right-of-use asset is calculated by adjusting the lease liability for initial direct costs incurred by the lessee, prepayments of lease payments, and receipts of lease incentives.
For existing capital leases, the amounts that are recorded as the capital lease liability and the associated asset will be reclassified to a “financing lease liability” and “financing lease right-of-use asset.”
Subsequent Measurement:
Once the financing lease liability and right-of-use asset are recorded on the books, each month the company will do the following:
- Accrete interest and increase financing lease liability (lease liability x interest rate)
- Reduce the lease liability by actual lease payment made
- Amortize financing lease right-of-use asset recorded on a straight-line basis
How Can We Help?
CDH is here for you every step of the way to help discuss potential issues with your banks or accountants, help you review your current and future leases and other vendor contracts, as well as assist with finding a lease software that fits your needs.
Contact Emily Bartlett, Senior Assurance Manager, and internal lease expert, at [email protected] for any questions on the new lease standards.