After years of delays, ASC 842 is now in effect for all companies in the United States. Ever since the new lease accounting standard was proposed, it was known that all leases would have to be reported as assets and liabilities on the balance sheet. That led to some uncertainty. How would this affect a company’s financial statements like balance sheet and income statement accounts? Wait, what would it mean to take on all those lease liabilities on the balance sheet?

Many businesses are going through their first year and first audit under the new leasing standard, and the true impact of lease liabilities on the balance sheet is a lot clearer. The results are in, and here’s a look at what has happened to companies' balance sheets.

What are lease liabilities and why do they now appear on the balance sheet?

Under ASC 842 and IFRS 16, lease liabilities must be recognized on the balance sheet because prior standards allowed operating leases to exist as unrecorded liabilities disclosed only in financial statement footnotes. If you’re wondering why such a significant change to accounting practices and financial reporting would be made in the first place, it helps to take a step back, to a time before the rule change.

Under the previous standard (ASC 840), operating leases were reported as notes on financial statements. Recognizing this as a lack in reporting transparency, the Financial Accounting Standards Board (FASB) came up with new methods for recording leases in ASC 842.

This includes the lease being recorded on the balance sheet as a right-of-use or ROU asset and corresponding lease liabilities. The ROU asset is a new concept introduced to lease accounting with FASB Accounting Standards Update, ASC 842 and the International Accounting Standards Board version called, IFRS 16.

What is a right-of-use asset and how is it calculated?

A right-of-use (ROU) asset represents the lessee's right to occupy or use a leased asset for a specific term. It is an intangible asset calculated as the present value of remaining lease payments, plus initial direct costs and prepaid rent, minus any lease incentives received.The “right-of-use” verbiage was chosen to distinguish between asset ownership and the right to use the leased asset. 

For example, if your company leases a dump truck, your asset is the right to use it, not the dump truck itself. In essence, this means the ROU asset is an intangible asset. 

So, how do you calculate this intangible asset and its liabilities? In short, the ROU asset is determined by starting with the initial liability of the lease, plus any initial direct costs and prepaid (or accrued) lease payments, less any incentives the lessee may have received. 

Writing the ROU asset calculation as a formula looks like this:

ROU asset = Lease liability present value of lease payments not yet paid + Initial direct costs incurred by the lessee + or - Lease payments made on or before the commencement date - Any applicable lease incentives.

Past standards only required accounts like prepaid or deferred rent to appear on balance sheets. In effect, those standards meant that all other operating leases were unrecorded liabilities.

So, this influx of liabilities on balance sheets is the most significant change of ASC 842 and one of the most significant changes ever made to accounting rules. Business owners, accountants, and other stakeholders contemplating these changes were left to update their lessee accounting processes, determine the asset's useful life, outline their internal controls and disclosure requirements all in an effort to ensure their balance sheets meet the GAAP accounting standards.

ASC 842 went into effect for private companies and non-profit organizations for fiscal years starting after December 15, 2021. Most public companies adopted the new standard before that. This means there are some real-world examples of the appropriate accounting treatment are live to help gauge the actual impact of lease liabilities on the balance sheet.

How does the ASC 842 balance sheet compare to the ASC 840 balance sheet?

Under ASC 840, operating leases were previously only in the footnote disclosure notes section of balance sheets and income statement accounts as well as other financial statements. ASC 842’s changes have brought the ROU assets and lease liabilities to the balance sheet, and some disclosure changes too.

Reports must now include several qualitative and quantitative disclosures. This includes the weighted average discount rate, the weighted average remaining lease term, cash paid on reported lease liabilities, and a more descriptive maturity analysis.

All of this extra information must be backed up by the figures reported on the balance sheet.

What journal entries are required each month under ASC 842?

Each month under ASC 842, operating lease activity requires three entries: a debit to lease liabilities and credit to cash for the rent payment, a debit to lease expense and credit to the ROU asset for amortization, and an accretion entry adjusting the lease liability to its updated present value.

Essentially, this means a debit to Lease Liabilities and a credit to cash outflows. This covers the actual cash outlay incurred in the month.

The amortization of the ROU asset would occur monthly, capturing the monthly lease activity in a debit to Lease Expense, a credit to ROU Asset, and a credit to Lease Liabilities.

The Lease Expense is the amount of straight-line rent expense over the term of the lease. The amount recorded on the Lease Liabilities account represents adjustments to arrive at the new net present value of the remaining payments.

Under ASC 842, rent expense is generally the same as before: straight-line over the lease term. 

There are material impacts to the income statement and the bottom line on a balance sheet. A potential variable here is the discount rate used to calculate the present value of the lease liability.

How do you determine the discount rate for calculating lease liability present value?

The discount rate for lease liability calculations should be the interest rate implicit in the lease if it is readily determinable. If not, lessees use the incremental borrowing rate, or for private companies, a risk-free rate practical expedient is available. ASC 842 requires that the interest rate implicit in the lease be used as the discount rate—if the implicit interest rate is known or can be readily determined. Since lessors don’t often share the rate with the lessee or disclose other information required to accurately calculate the implicit interest rate.

In those cases, the lessee should use the company’s incremental borrowing rate. This is the interest rate the lessee would have to pay to borrow money on a collateralized basis over a similar term and amount that equals the lease payments in a similar economic environment.

As you can see, the incremental borrowing rate is not an easy answer when a lease’s implicit interest rate can’t be reasonably determined. Smaller and startup businesses may have little experience in acquiring collateralized loans, and what constitutes a “similar economic environment” is open to interpretation.

For private companies, there is a practical expedient available that allows them to use a risk-free rate as their discount rate. When a private entity does not know the implicit interest rate or determining an incremental borrowing rate is difficult, using the risk-free rate seems like an attractive option.

The risk-free rate is readily available since it’s published daily by the US Treasury. However, the risk-free rate will typically be lower than an incremental borrowing rate, which will result in a larger lease liability and ROU asset.

Therefore, the method chosen to arrive at the discount rate can have a significant impact on overall lease liabilities. In particular, private companies electing to use the risk-free rate should do so with caution, giving careful consideration to the impacts of making this election or other expedients.

How does ROU asset impairment affect the balance sheet and financial reporting?

When an ROU asset is impaired its carrying value is reduced to fair market value, which depresses net income in the period of impairment and can create volatility across comparative financial statements in subsequentThe carrying value is thus reduced to the asset’s fair market value.

Impairments should be applied to tangible and intangible assets. Since ASC 842, this now includes the ROU asset.

The US Generally Accepted Accounting Principles (US GAAP) requires companies to evaluate assets for possible impairment if a significant change has occurred. If, for instance, a business undergoes a substantial change in financial circumstances, certain long-lived assets may now be overvalued, requiring an impairment analysis.

When an ROU asset is impaired, it can start a series of effects on comparative financial statements. Net income will be depressed in the period of impairment and then enhanced in subsequent periods as the value of the ROU asset is lowered.

A period with many impairments could produce ripples of volatility in financial reporting. From a lease liability perspective, problematic equipment could thus have one of the biggest impacts on balance sheets.

How do lease liabilities under ASC 842 affect EBITDA and financial ratios?

When an ROU asset is impaired, its carrying value is reduced to fair market value, which depresses net income in the period of impairment and can create volatility across comparative financial statements in subsequent periods. This has a direct impact on key financial ratios such as EBITDA.

For example, imagine an operating lease is classified as a long-term asset while the corresponding lease liability is separated into short-term and long-term liabilities. Compared to accounting under prior standards, the ROU adds to the figures for non-current assets, current liabilities and non-current liabilities.

The net result will be a slightly lower current ratio (the value of current assets divided by current liabilities). This has a direct impact on EBITDA and related calculations like the debt to net worth ratio, funded debt to EBITDA, and debt service coverage.

In the end, this shouldn’t significantly affect the balance sheet in a carefully considered ASC 842 implementation. However, this assumes the calculation of cash flows, discount rates, and other figures have been optimized for the company in question.

What should finance teams know about implementing ASC 842 lease liability reporting?

A properly implemented ASC 842 transition increases balance sheet transparency but requires careful decisions around discount rate methodology, ROU asset measurement, and ongoing journal entry processes that affect reported financial ratios.

For companies that depend on leased assets, the amount recorded on financial statements is greater than before. This has the potential to have a material impact on financial ratios. The initial measurement of the right-of-use asset and lease liability is the same for operating and finance leases, while the expense recognition and amortization of the ROU asset differs 

The intricacies involved in arriving at the discount rate can also play a major impact in the reporting of lease liabilities. The wide range of calculation approaches available to a company—implicit interest rate, incremental borrowing rate, the risk-free rate—all have their pros and cons. Selecting one method over the other can make a noticeable difference in reported lease liabilities.

The time and effort spent on implementation will have an invisible effect on a company’s bottom line in the beginning. The burden of changing processes, modifying reporting practices, and creating new procedures took up a lot of time for CFOs, Controllers, accounting directors, and the other members of finance teams. A lot of hours worked didn’t go toward creating and implementing the company’s other financial strategies.

How does lease accounting software help finance teams manage lease liabilities correctly?

ASPurpose-built lease accounting software automates ROU asset calculations, monthly journal entries, and discount rate application, so real estate and finance teams maintain ASC 842 compliance without manual risk at month-end close. The caveat here is that your company needs to make the right choices in your ASC 842 implementation and how your finance team applies its rules. That’s where you need software designed specifically for the intricacies of lease accounting. 

Occupier leverages a modern and innovative tech stack that ensures your compliance with new standards. And that’s just the tip of the iceberg. Occupier helps automate much of your lease accounting, making month-end close quicker and easier than ever. If you're ready to see how Occupier can streamline your entire lease accounting lifecycle, get in touch with us today and schedule a demo.