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The impact of ASC 842 on ROU calculation
The release of ASC 842 impacted both the balance sheets and income statements for companies regarding their leases. Under the old standard, companies could configure agreements so that leases were presented in a favorable way, even if the underlying economics of the transaction might have told a different story.
One of the balance-sheet items that must be recorded is the right-of-use (ROU) asset. The ROU asset represents a lessee’s right to use an asset over the life of the lease.
Key Takeaways:
- The three approaches to calculating lease liabilities are: Approach #1 (summing the principal to be paid over the upcoming 12 months); Approach #2 (using the lease liability’s effective interest rate to separately calculate the present value of the lease liability as the long-term portion, and for the short-term portion calculate the present value of the upcoming 12-month payments); and Approach #3 (summing the undiscounted payments that are due in the upcoming 12 months)
- Netgain has chosen to use Approach #1 as it most closely resembles the guidance for the presentation of the current portion of long-term debt
- The short-term portion of the lease liability is calculated by summing the principal to be paid over the upcoming 12 months. The remaining amount is the long-term portion of the liability
Why did this change come about?
Under ASC 840, some companies structured agreements so that all payments would be expensed in the period paid, and no liability would be presented on the balance sheet. Regulators took note of companies that took advantage of this loophole and investigated further. These agreements smelled a lot more like liabilities that should be presented on the balance sheet, and, thus, ASC 842 was born.
Under ASC 842, a contract is a lease “…if the contract conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration…”
If a contract meets this definition, two balance-sheet impacts will be made: an asset and a liability. Depending on the terms of the lease, the lease may be classified as an operating lease or a financing lease. These two classifications have some accounting differences, so the classification is important. The remainder of this article will discuss the asset piece and how it is calculated for operating-type leases.
How to calculate the ROU asset
When calculating the ROU asset amount to be booked to the balance sheet, there are several inputs. The overall idea here is that we’re taking the net present value of the payments and booking the ROU asset based on that amount. The incremental borrowing rate of the company is broadly used and is accepted as the discount rate in the Net Present Value (NPV) calculation. There are a few inputs that should also be considered when performing this calculation. These include prepayments, initial direct costs and lease incentives.
Download Netgain’s free NPV calculator to follow along below with the example below.
Let’s go through a simple example of a lease and the calculation of the ROU asset. We will assume the following terms of the lease and that payment is made in arrears:
- 60-month term
- $1,000 payment made monthly
- 4.5% incremental borrowing rate
Below, you can see the first 3 months of the schedule based on these inputs. The NPV equation used is as follows with “r” as the monthly incremental borrowing rate:
NPV = (1st Payment / r ^ Period #) + (2nd Payment / r ^ Period #) + … + (Last Payment / r ^ Period #)
Once this ROU asset has been booked, it will be amortized over the term of the lease. There will be the corresponding lease liability as well, and these impacts can be major for companies moving to ASC 842.
Automate amortizations instead
When considering how to handle this transition, a lot of companies have built a spreadsheet for each lease to track the amortization schedule. With all these inputs—not to mention modifications of leases—using a separate schedule for each lease quickly becomes burdensome and error-prone. That’s when using a tool such as NetLease can save a lot of time and energy and bring immediate compliance.
Bottom line:
The calculation of these balance-sheet amounts is at the heart of the lease-accounting standard. Getting this right is critical to being compliant. Unfortunately, this has added some complexity. Use the information above to nail it!
Lean more about NetLease or request a demo.
FAQs
What Is ASC 842 Simplified?
The ASC 842 standard for GAAP lease accounting requires all leases longer than 12 months to be recorded as assets and liabilities on balance sheets. This new standard was developed by the Financial Accounting Standards Board (FASB) to promote more openness between investors and businesses.
ASC 840, the previous GAAP lease accounting standard, has been replaced by ASC 842, which prevents some leases from being categorized as "operating leases" and from being capitalized on the balance sheet. They were consequently left out of numerous financial analysis ratios, such as return on assets, and these omissions could misrepresent a company's performance to an investor.
All firms that adhere to generally accepted accounting rules, or GAAP, are now required to classify every lease as both a liability and a right-of-use asset under ASC 842.
What is the difference between ROU asset and lease liability?
ASC 842 and IFRS 16 both include the right-of-use (ROU) asset as a crucial part of their current lease accounting standards. The ROU asset is a lessee's entitlement to make use of a leased asset during the period of the lease.
Typically, the leased assets in question are pieces of furniture or machinery. Yet, anything for which a lessee is given permission to use an asset controlled by another organization in order to benefit financially qualifies as a ROU asset.
In simpler terms, an ROU asset is a lease asset. A lease liability is the lessee's discounted financial responsibility to make the payments outlined in the lease agreement.
What is an operating right-of-use asset?
A lessee's right to use a leased asset, usually property or equipment, for the duration of the agreed-upon lease period is known as a right-of-use asset, or ROU asset. In other words, the lessee is given the authority to reap financial rewards from the use of a resource that belongs to another party. This asset is referred to as the "lease asset" in accordance with GASB 87.
According to all three standards (ASC 842, IFRS 16, and GASB 87), a lease liability is the financial obligation to make lease payments that is calculated on a discounted basis.
Where does the operating lease right-of-use asset go on the balance sheet?
When the Federal Accounting Standards Board published ASC Topic 842, Leases, in 2016, operating lease accounting changed. The new standard offered guidelines when it came to accounting for leases, requiring that the lease and its associated asset value be shown on the balance sheet. Nonetheless, the straight-line basis technique can be used to account for leases that are shorter than a year in length as an expense.
When a lease of greater than 12 months is started, the lessee must record it on the balance sheet as both a lease liability and a right-of-use asset. The goal of the modification is to make a more accurate portrayal of a company's rights and responsibilities and to make it harder for companies to manipulate the balance sheet.
Does ASC 842 apply to operating leases?
The simple answer is, yes, ASC 842 applies to both finance and operating leases.
Here’s a brief explanation: The recognition of lease assets and lease liabilities on the balance sheet for leases that were classified as operating leases under the prior standards is the main difference between the old and new lease accounting rules. As you surely recall, operating leases were previously considered to be "off balance sheet" transactions.
Lessees are now required to record all leases with durations longer than 12 months on the balance sheet in accordance with ASC 842. These leases are currently classified as "Operating" or "Finance" leases. Under prior GAAP, finance leases were known as capital leases, but under the current standard, this sort of lease is generally defined the same way.
