The FASB ASC 842 new Lease Accounting Standards have thrown a curve ball to many companies’ financials. The changes present a significant impact on a companies’ balance sheet. It is a good standard because, the changes result in a faithful presentation of the financials. A reader of the balance sheet can now ascertain what a companies’ long-term obligations are with respect to leases. What is the new lease standard and how do you account for it?
A lease is a contractual agreement between a lessor and lessee granting the lessee a right to use identified assets for a period of time in an exchange for a consideration usually, in a form of money.
Classification of Leases
From the lessee perspective (which is what this blog is about), leases can be classified as a short term lease, operating lease, and finance lease.
Short Term Lease
A short term lease is a lease with a term of 12 months or less. The accounting for a short term lease is to debit expense and credit cash each month payment is made. However, under the new lease standards, when a lease term is more than 12 months, it is classified as either an operating lease or finance lease and an asset and lease liability are recorded.
The determination of whether a lease is an operating or finance lease depends on meeting one of the following five criteria:
- Transfer of ownership test – Title of the lease transfers ownership at the end of the lease.
- Bargain purchase option test – There is a provision for a bargain purchase option.
- Lease term test – The lease term equal to or greater than 75% of the economic life of the lease.
- Present value test – The present value of minimum lease payments plus the residual guarantee by lessee is equal to or greater than 90% of the fair value of the asset.
- Alternative use test – The asset has no alternative uses.
If any one of the above five criteria is true, the lease is classified as a finance lease. On the other hand, if the lease is more than one year and none of the five criteria is not met, the lease is classified as an operating lease.
An operating lease is a lease with the term greater than 12 months but does not qualify as a finance lease. The accounting for operating lease is to record both lease as an asset and as a liability on the balance sheet. The initial entry is as follows:
Debit Right of Use Asset
Credit lease liability
The Right of Use asset is then amortized while the lease liability will be reduced by the payments. Prior to the new lease standards, operating leases did not have any balance sheet impact. With the implementation of the new lease standards, public companies may be required to convert all their operating leases into the balance sheet.