In this post I will explain how to transition from the current lease accounting rules to the new lease accounting rules. Specifically, we will discuss how to go from an operating lease under current GAAP to an operating lease under the new lease accounting rules, also known as Topic 842. Here are the steps to transition an operating lease from current GAAP to topic 842:
Step 1: Identify remaining lease term (from the beginning of the earliest comparative period presented)
Step 2: Identify remaining payments over remaining lease term from Step 1
Step 3: Calculate present value of remaining payments from step 2 over remaining lease term using discount rate as of effective date (This is the Lease Liability)
Step 4: Adjust amount in Step 3 for any prepaid or deferred rent (This is the ROU Asset)
Let’s explain the steps with an example. Consider the following scenario:
10-year lease commenced January 1, 2015
Annual payments of $10,000/yr in years 1 through 5 (paid in arrears), and $15,000/yr in years 6 through 10
Transition date is January 2019. Incremental borrowing rate on transition is 6%
3-year comparative period displayed in Income and cash flow statements (So this is a publicly traded company. Private companies would only have 2-year comparative periods).
Step 1: Identify the remaining lease term (from the beginning of the earliest comparative period presented):
In 2019, the income statements displayed will be for 2019, 2018 and 2017, so the earliest comparative period presented is 2017. From 2017, the remaining lease term is 8 years.
Step 2: Identify remaining payments over remaining lease term (from the beginning of the earliest comparative period presented):
The remaining payment schedule is as follows:
Step 3: Calculate present value of remaining payments over remaining lease term using discount rate as of effective date (this is the lease liability)
Lease liability amortization schedule of remaining payments is as follows:
To see my blog on how to calculate the present value of lease payments, click here. Please note that this means that the lease liability is 79,782.
Step 4: Adjust amount in Step 3 for any accrued or deferred rent (this is the ROU asset)
The following is the (previous) straight line amortization schedule for the lease under the current accounting rules for operating leases:
You can see that the deferred rent balance as of January 2017 is $5,000. So the ROU asset balance is:
79,782 – 5,000 = 74,782.
If making an entry in January 2017, it would be:
Journal entry at earliest comparative period
Dr ROU Asset 74,782
Dr Deferred Rent 5,000
Cr Lease Liability 79,782
The lease liability will be amortized based on the lease amortization schedule from Step 3 above (a portion of each payment goes to interest expense, and the balance reduces the lease liability). So in 2017, a payment of $10,000 will be made; $4,787 will be allocated to Interest Expense, and the lease liability will be reduced by $5,213.
To determine how to calculate the present value of minimum lease payments, click here.
To summarize, here are the steps to go from current GAAP to an operating lease under the new lease accounting standard (Topic 842).
In a subsequent post, I will explain how to go from an operating lease to a Type A lease. If you have any questions, please leave a comment below.