New Lease Standard – Part 2: Operating Leases and ROU Assets

By November 2nd, 2022 November 19th, 2022 Audit

The major change in the new lease standard (ASC 842) is the treatment of operating leases on the lessee side. The new lease standard (ASC 842) has introduced a new concept of “Right of Use Asset” (ROU asset), which is defined as an asset that represents a lessee’s right to use an underlying asset for the lease term and is used for both finance leases and operating leases.

We will touch on the theoretical aspects later, but for now, let’s look at what it means to on-balance an operating lease using an example.

[Example 1]

The lease is for 5 years, and the lease payments are made at the end of each year in increments of 5,000, 10,000, 15,000, 20,000, 25,000. The discount rate is 9%, and the present value of the total lease payments based on this rate is 55,000. The lease is determined to be an operating lease.

The lease is tabulated according to ASC 842 as follows:

Total 75,000 20,000 55,000   55,000   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)    
Initial balance     55,000   55,000  
1 5,000 4,951 49 54,951 10,049 44,951 15,000
2 10,000 4,947 5,053 49,898 10,053 34,898 15,000
3 15,000 4,492 10,508 39,390 10,508 24,390 15,000
4 20,000 3,546 16,454 22,936 11,454 12,936 15,000
5 25,000 2,064 22,936 12,936 15,000

 

 

The calculation of lease expense is no different than under ASC 840. The total lease payments are recognized straight line over the lease term. In the example, it is 15,000/year (g). The initial amount of the lease obligation is 55,000 (d). As with a capital lease, interest (b) is calculated and the remaining amount is used to reduce the lease obligation (c), but the interest is not shown as interest expense on the income statement.

The initial amount of the ROU asset is 55,000 (f), the same as the lease obligation, and the amortization amount (e) of this ROU asset is produced by subtracting the amount equivalent to interest (b) from the lease expense (g) and plugging it in. As with interest, it is not shown as an amortization expense on the income statement.

This means that the lease expense (15,000) in each period consists of the  interest expense component and the ROU asset amortization expense component, and interest expense and amortization expense will not be separately presented in the income statement.  The impact on the P/L will be the same for ASC 840 and ASC 842.

[Example 2]

The lease is the same as in Example 1, but it is determined to be a finance lease. The asset is depreciated using the straight-line method.

Total 75,000 20,000 55,000   55,000   75,000
Year Lease Payments Interest Decrease in lease liability Lease liability ROU asset Amortization ROU asset Lease expense
    P/L   B/S P/L B/S  
  (a) (b) (c) (d) (e) (f) (g)
      =(a)-(b)       =(b)+(e)
Initial balance     55,000   55,000  
1 5,000 4,951 49 54,951 11,000 44,000 15,951
2 10,000 4,947 5,053 49,898 11,000 33,000 15,947
3 15,000 4,492 10,508 39,390 11,000 22,000 15,492
4 20,000 3,546 16,454 22,936 11,000 11,000 14,546
5 25,000 2,064 22,936 11,000 13,064

This remains unchanged from ASC 840 to ASC 842. Interest expense (b) is still presented as interest expense on the income statement and amortization expense (e) of ROU asset is presented as amortization expense.

Since interest expense (b) and amortization of ROU asset (e) are not directly linked, lease-related expenses (g), which is the sum of interest expense (b) ROU asset amortization (e), will naturally differ each year when compared to lease expense (g) in Example 1. However, the total amounts will match.

[Example 3]

If Example 1 is processed according to ASC 840.

Total 75,000 75,000  
Year Lease Payments Lease expense Deferred rent(single year) Deferred rent(accumulated)
    P/L   B/S
  (a) (g) (h) (i)
      =(a)-(g)  
       
1 5,000 15,000 (10,000) (10,000)
2 10,000 15,000 (5,000) (15,000)
3 15,000 15,000 (15,000)
4 20,000 15,000 5,000 (10,000)
5 25,000 15,000 10,000

Under the old standard, of course, neither the lease obligation nor the ROU asset is recognized on the balance sheet, but deferred rent (i) is recognized on the balance sheet because the total lease payments of 75,000 are levelized and recognized over five years. This is the cumulative difference between the lease expense and the actual lease payments (h) for each year, and the balance is zero at the end of the lease.

Will ASC 842 eliminate deferred rent?

Is deferred rent recognized in ASC 840 not recognized in ASC 842? It is not recognized in the same sense because it is not presented as deferred rent on the balance sheet. On the other hand, it is included in the difference between the lease obligation and the ROU asset as shown below and is recognized in that sense.

Total 75,000 20,000 55,000   55,000   75,000  
Year Lease Payments Interest Decrease in lease liability Lease liability ROU asset Amortization ROU asset Lease expense Deferred rent(single year) Deferred rent(accumulated)
        B/S   B/S P/L    
  (a) (b) (c) (d) (e) (f) (g) (h) (i)
      =(a)-(b)   =(g)-(b)     =(c)-(e) =(f)-(e)
Initial balance     55,000   55,000      
1 5,000 4,951 49 54,951 10,049 44,951 15,000 (10,000) (10,000)
2 10,000 4,947 5,053 49,898 10,053 34,898 15,000 (5,000) (15,000)
3 15,000 4,492 10,508 39,390 10,508 24,390 15,000 (15,000)
4 20,000 3,546 16,454 22,936 11,454 12,936 15,000 5,000 (10,000)
5 25,000 2,064 22,936 12,936 15,000 10,000

As can be seen from the above table, the difference between the decrease in lease obligation (c) and ROU asset (e) is the amount of deferred rent accrual (h) for each year. Then, the net amount of the balance between the lease obligation (d) and the ROU asset (f) is the cumulative amount of deferred rent (i). Compare this with Example 3.