In our last look into ASC 842 implementation, we covered the importance of anticipating the intensive effort required in implementing the standard. Knowing that, implementing a third-party solution to perform the accounting and reporting of leases under Accounting Standards Codification Topic 842 (or “ASC 842”) makes the most sense given a large lease population or complex leasing arrangements. Comprehensive lease accounting solutions provide administrative ease by producing periodic journal entries and requisite financial statements note disclosures at a proverbial press of a button. However, it is incumbent upon a company’s accounting and finance leadership to understand the intricacies of how their lease accounting solution derives its outputs under the auspices of ASC 842.
ASC 842 lease accounting is indeed complex and voluminous by design to provide guidance on the various leasing scenarios companies participate in. But the goal of this post is not to be comprehensive. Rather, this article will focus on an operating lease scenario that numerous companies have currently represented in their lease population. I hope it can provide a bit more insight into areas of interest to finance leaders when analyzing and forecasting lease obligations.
A Lease Accounting Scenario
A company signs a real property lease for 36 months commencing on January 1, 2020. Rent is $100,000 a month (paid at the beginning of the month) for the first year and escalates 15% annually. As a lease incentive, the first three months of rent are abated and a leasehold improvement allowance of $50,000 will be paid to the lessee on March 1, 2020, upon lessor’s final approval of leasehold improvements. As the company is not a public business entity, it opted to implement ASC 842 with an effective date of January 1, 2021 and has determined its incremental borrowing rate (IBR) to be 5.0% as of the effective date. The company has elected to take advantage of the transition relief, which allows for comparative periods presented in the financial statements not to be restated under ASC 842.
Lease Accounting Prior to ASC 842 (ASC 840)
Prior to adopting ASC 842, the company would have been recording rent expense on a straight-line basis of $107,417 a month. Given the three months of rent abatement and annual escalation in rent, the company would have a deferred rent liability balance of $389,004 as of December 31, 2020, to account for the difference between actual cash payment and straight-line rent expense. Furthermore, the company would record the leasehold improvement allowance to a lease incentive liability account and amortize (to rent expense) over the life of the lease to a balance of $35,290 as of December 31, 2020.
Transition to Lease Accounting Under ASC 842
On January 1, 2021, the company adopts ASC 842, and based on the remaining lease payments and 5% IBR, total (current and non-current) lease liability of $2,824,141 is recorded with an offsetting entry to a right-of-use (ROU) asset. In addition, the initial measurement of the ROU asset also includes the deferred rent and lease incentive liabilities balances as well as initial direct lease costs (which there are none in this scenario). The two liability balances are then reclassified accordingly, and the initial ROU asset for this lease totals $2,399,847.
To be able to reconcile lease liabilities to corresponding ROU assets will undoubtedly provide finance leaders insight into the company’s lease population and better forecast future impacts to the financial statements. Also, a company’s finance leadership may want to track each ROU asset component separately via additional general ledger accounts if the lease accounting solution doesn’t already provide that level of detail.
From an income statement perspective, there should be no material change in rent expense between pre- and post-ASC 842 adoption in the lease scenario provided. While the straight-line rent expense calculation under ASC 842 is based on the remaining lease payments over the remaining term of the lease ($123,625 per month), the amortization of the deferred rent liability reclassified to ROU asset offsets rent expense to match straight-line rent expense prior to ASC 842 adoption. Amortization of the lease incentive liability remains the same under ASC 842 as it was under ASC 840.
The simplified scenario discussed herein highlights the many moving parts that ultimately renders down to a summary journal entry supplied by a lease accounting solution. While a lease accounting solution offers speed and convenience when providing ASC-842-related deliverables, the company’s finance leaders are still responsible for understanding how the outputs are derived and be able to perform insightful, timely and accurate analyses of their current lease population.
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About the Author
Kevin is an accounting and finance professional with nearly 20 years of experience. He started his career in San Francisco in the audit and assurance service division of Deloitte serving major public and private clients spanning banking and finance, not-for-profit, manufacturing and hospitality industries. Subsequently, he joined PG&E Corporation serving first in the regulatory accounting group and later as an accounting supervisor in the corporate reporting group. Kevin moved to Los Angeles and joined the Corporate Controllership team at The Walt Disney Company and enjoyed many successful years as a Senior Manager leading efforts pertaining to equity-based compensation and SEC and other external reporting for the Media, Theme Parks and Studio segments. Prior to joining 8020 Consulting, Kevin had previous consulting experience ranging from SEC reporting, process improvement, monthly close, forecast and budgeting, and project management at clients like Toyota Motor Credit Corporation and Southern California Edison. Kevin is a Certified Public Accountant and holds a Bachelor’s of Science degree in Accounting from the University of San Francisco.