In this article, we will look at the transitional provisions when the new lease standard is applied in 2022. Since this is a change in accounting standards, retrospective application is the principle. However, since retrospective application is complicated, there are two transition methods as follows:
ASC 842-10-65-1
- Retrospectively to each prior reporting period presented in the financial statements with the cumulative effect of initially applying the pending content that links to this paragraph recognized at the beginning of the earliest comparative period presented. Under this transition method, the application date shall be the later of the beginning of the earliest period presented in the financial statements and the commencement date of the lease.
- Retrospectively at the beginning of the period of adoption through a cumulative-effect adjustment, Under this transition method, the application date shall be the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph.
Comparative method
Method 1 is called the comparative method or modified retrospective method. This is a method close to the principle in accounting method change.
The concepts of “application date”, “effective date”, and “transition period” are used for transitional measures: application date is the date when the new lease standard is applied, effective date is the date when the new lease standard is adopted, and the transition period is the period between the earliest date of the financial statements presented and the effective date.
If a calendar year company prepares financial statements for both 2021 and 2022, the application date, effective date, and transition period are as follows: The application date is January 1, 2021 or the lease commencement date, whichever is later.
| 1/1/2021 | Earliest date presented ⇓ ⇓ Transition period （Application date=later of 1/1/2021 or commencement date） ⇓ |
| 1/1/2022 | Effective date |
| 12/31/2022 | Year end |
Therefore, if there is an operating lease on January 1, 2021, the ROU asset and the lease liability will be recognized on January 1, 2021, and basically applied retroactively to January 1, 2021. In addition, for leases that commenced in the transition period, the commitment date will be the application date, and the accounting treatment will be in accordance with the new lease standard.
Effective date method
On the other hand, method 2 is called the Effective date method or the current-period adjustment transition method, and is as follows
| 1/1/2021 | Earliest date presented ⇓ ⇓ Apply ASC840 ⇓ |
| 1/1/2022 | Effective date (= Application date) |
| 12/31/2022 | Year end |
In other words, the Application date is January 1, 2022, and until that date, the old lease standards of ASC 840 will apply. Therefore, even if the financial statements for 2021 are presented comparatively, they will still be presented under the old ASC 840 for 2021; ASC 842 will only appear after January 1, 2022. For simplicity, we believe that most non-public companies will use the effective date method.
【Example】
Let’s look at what exactly is done according to the Effective date method.
A lessee enters into a five-year lease from January 1, 2020, through December 31, 2024, paying lease payments at the end of each year in increments of 5,000, 10,000, 15,000, 20,000, 25,000. The lease is determined to be an operating lease under ASC 840. The new lease standard ASC 842 will be applied using the effective date method.
| Year | Lease payments | Lease expense | Deferred rent(single year) | Deferred rent(accumulated) |
| =(a)-(g) | ||||
| P/L | B/S | |||
| (a) | (g) | (h) | (i) | |
| Total | 75,000 | 75,000 | – | |
| 1/2020 | ||||
| 12/2020 | 5,000 | 15,000 | (10,000) | (10,000) |
| 12/2021 | 10,000 | 15,000 | (5,000) | (15,000) |
| 12/2022 | 15,000 | 15,000 | – | (15,000) |
| 12/2023 | 20,000 | 15,000 | 5,000 | (10,000) |
| 12/2024 | 25,000 | 15,000 | 10,000 | – |
At the end of 2021 and beginning of 2022, the cumulative lease expense recognized up to two years is 30,000 recognized and the B/S is as follows
B/S (Cr) deferred rent (15000)
The new standard for operating leases will be applied with an application date of the beginning of 2022.
Calculation of lease obligations and ROU asset
To apply it, you must first come up with a present value of the lease obligation, applying the discount rate available at the time of the Application date (1/1/2022). In this case, it is a matter of choice of accounting policy whether to take the rate of interest over the 3-year remaining lease term or over the 5-year term of the original lease. In this example, the latter is used. Also, in this example, the simplified method for private companies (ASC 842-20-30-3) will be used and the risk-free rate will be used. Assume that the 5-year risk-free rate obtained as of 1/1/2022 is 1.5%.
The present value of the lease payments from 12/2022 to 12/2024, discounted at 1.5%, is 58,086, which is the lease obligation. The ROU asset is 43,086 =(lease obligation)-(Deferred rent).The lease expense is equal to the remaining lease payments (15,000, 20,000, and 30,000) and the portion corresponding to the deferred lease (15,000 that has already been expensed) over three years, so ((15,000 + 20,000 + 25,000) – 15,000)/3 equals 15,000 per year. The amount equivalent to amortization of the ROU asset is (15,000 – amount equivalent to interest).
| Total | 75,000 | 4,000 | 71,000 | 71,000 | 75,000 | ||
| Year | Lease payments | Interest | Decrease in lease liability | Lease liability | ROU asset Amortization | ROU asset | Lease expense |
| B/S | B/S | P/L | |||||
| (a) | (b) | (c) | (d) | (e) | (f) | (g) | |
| =(a)-(b) | =(g)-(b) | ||||||
| 1/2020 | 71,000 | 71,000 | |||||
| 12/2020 | 5,000 | 1,073 | 3,927 | 67,073 | 13,927 | 57,073 | 15,000 |
| 12/2021 | 10,000 | 1,013 | 8,987 | 58,086 | 13,987 | 43,086 | 15,000 |
| 1/2022 | 58,086 | 43,086 | |||||
| 12/2022 | 15,000 | 878 | 14,122 | 43,964 | 14,122 | 28,964 | 15,000 |
| 12/2023 | 20,000 | 664 | 19,336 | 24,628 | 14,336 | 14,628 | 15,000 |
| 12/2024 | 25,000 | 372 | 24,628 | – | 14,628 | – | 15,000 |
The specific journal entries after January 1, 2022 will be as follows
Journal entries for 1/1/2022
| (Dr.) | ROU asset (B/S) | 43,086 |
| Deferred rent (B/S) | 15,000 | |
| (Cr.) | Lease liability(B/S) | 58,086 |
Deferred rent is converted to the difference between the RUA and the lease obligation in the journal entry above.
Journal entries for 12/31/2022
| (Dr.) | Lease obligations | 14,122 |
| Lease expense(equivalent to interest expense) | 878 | |
| Lease expense（equivalent to RUA amortization） | 14,122 | |
| (Cr.) | ROU asset | 14,122 |
| Cash | 15,000 |
Journal entries for 12/31/2023
| (Dr.) | Lease obligations | 19,336 |
| Lease expense(equivalent to interest expense) | 664 | |
| Lease expense（equivalent to RUA amortization） | 14,336 | |
| (Cr.) | ROU asset | 14,336 |
| Cash | 20,000 |
Journal entries for 12/31/2024
| (Dr.) | Lease obligations | 24,628 |
| Lease expense(equivalent to interest expense) | 372 | |
| Lease expense（equivalent to RUA amortization） | 14,628 | |
| (Cr.) | ROU asset | 14,628 |
| Cash | 25,000 |
Practical Expedients
In addition, the following simplified method is permitted under ASC 842-10-65-1 at the time of transition.
- An entity need not reassess whether any expired or existing contracts are or contain
- An entity need not reassess the lease classification for any expired or existing leases.
What is considered an operating lease under ASC 840 is also an operating lease under ASC 842, and what is considered a capital lease under ASC 840 is a finance lease under ASC 842. (An entity need not reassess the lease classification.) - An entity need not reassess initial direct costs for any existing leases.
In other words, the provision carries over judgments made under ASC 840 as is, but it assumes that the judgments made under ASC 840 were correct. Therefore, if it turns out that the judgment under ASC 840 was wrong in the first place, the selection cannot be taken over as is. In addition, 1 through 3 must be selected or deselected together as a single package.
In addition, if the comparative method is used, subsequent information can be used to determine the lease term (renewal, termination, use of purchase options) and the impairment of the ROU asset.
