Your Guide To Calculating Journal Entries For Operating Leases

When it comes to accounting for operating leases, ASC 842 has imposed several new requirements that must be adhered to.

The FASB ASC 842 improves disclosure and transparency on the leasing liabilities of organizations of all types, including public and private ones. It is an effort towards boosting visibility in the financial statements reported by businesses.

One ought to be aware that leases now reflect on the balance sheet as a liability for the lease and an asset for the right to use the leased property.

Therefore, in this article, we will go through the primary requirements and steps to be followed while accounting for operating leases and making journal entries precisely, in accordance with ASC 842.

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Journal Entry for an Operating Lease Under ASC 842

 According to ASC 842, journal entries for operating leases are as follows:

• Lease liability - It corresponds to the present value of all lease payments, which are yet due on the contract.
• ROU (right-of-use) asset - It refers to the rights that a business exercises over the underlying asset it is leasing. These rights will be amortized during the asset's lifetime. In this scenario, the productive asset life is equal to the length of time that the lease contract is in effect, which is commonly estimated in months.

It is necessary to have a solid understanding of the computations needed for these journal entries. Following the new standard, the calculation of a company's journal entries must begin with the creation of a lease amortization schedule. 

Steps Involved in the Calculation of ASC 842 Journal Entries

Here are a few steps that must be followed, each of which is discussed with an example, to accurately submit ASC 842 journal entries and verify that the balance sheet numbers are precise.

1. Recognizing ROU Assets and Lease Liabilities

Let's consider an operating lease on 1st January 2023 with the following initial values:

• Lease liability: $112,000
• ROU asset: $112,000

As a result, the new journal entries required by ASC 842 to recognize the lease commencement would look like the following:

• The ROU asset account experienced a debit of $112,000 on 1st January 2023.
• A credit of $112,000 under the lease liability account on 1st January 2023.

The accounts for the ROU asset and lease liabilities now get included in the process of totaling the figures on the balance sheet.

2. Recognizing Lease Liability Payments and Amortization of the ROU Asset

Regardless of the recurrence of the reporting, one would see the following:

• Every payment, including any direct expenditures that were incurred initially
• Interest accumulated on lease liabilities
• ROU asset amortization

Note that this is based on the assumption that there have been no changes made to the entries. The handling of modifications is a different process, which is discussed later on. 

These ASC 842 journal entries follow the format of monthly reporting because most firms use this frequency for their reporting schedule. The following would constitute the journal entries for January.

As a reflection of the payment made:

• On January 1st, $112,000 got debited from the lease liability account.
• On January 1st, $112,000 got credited to the cash account.

To take into account amortization:

• From 1-31 January, $10,000 got debited for lease expenses.
• From 1-31 January, ROU assets were credited with $10,000.

To account for interest expenses:

• From 1-31 January, a lease expense debit of $2,000 was made.
• From 1-31 January, a credit of $2,000 was applied to the lease liability.

The ROU value for January decreased as a result of amortization, and a rise in the value of the lease liability is reflected in the interest expense.

3. Maintaining a Consistent Record of Journal Entries up Until the Lease Expiry

The company will keep posting journal entries at the reporting frequency that it has chosen until the time that the lease concludes, provided that there have been no modifications made to the lease agreement.

Following the posting of those journals, the lease liability and the right-of-use asset would get reduced to zero.

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4. Accounting for Modifications

In case of a modification in the lease contract, the effective date of a modification requires accountants to review the value of ROU assets and lease liabilities.

Consider the following scenario: On July 15, one finds out that the monthly payments of $10,000 are going to increase to $12,000 starting August 1. A 6% increase has been applied to the discount rate modification.

Since this adjustment will have an effect on the company's prospective cash flow statement regarding the liability's current value, accountants will need to make an entry in the journal to reflect the re-measurement of this asset.

In the re-measurement journal entry, the following computation reflects the difference between these cash-paid amounts as a result of the re-measurement:

• Lease liability prior to modification - $102,000
• Lease liability post modification - $115,000
• Movement - $13,000

So, here is how the company would document July.

Reflecting July’s payment:

• July 1 - Lease liability got debited by $102,000
• July 1 - Cash account got credited by $102,000

Representing the subsequent modification:

• July 15 - ROU asset got debited by $13,000
• July 15 - Lease liability got credited by $13,000

Representing amortization:

• July 1 – 31 - Lease expense got debited by $60,000
• July 1 – 31 - ROU asset got credited by $60,000

Representing interest expense:

• July 1 – 31 - Lease expense got debited by $690
• July 1 – 31 - Lease liability got credited by $690

The new adjusted payment schedule would be shown in August's journal entries as follows:

• August 1 - Lease liability got debited by $115,000
• August 1 - Cash account got credited by $115,000.

When reporting, the subsequent journal entries will follow the same line of logic as was used for reporting on previous months.

Also, it's crucial to keep in mind that there are modifications to these entries as the scope expands, even if this is a simple operation. 

The operating lease journal entries would not adhere to the same reasoning as the original evaluation if the scope gets reduced.

The scope reduction is accounted for in subsequent processes. A lessee proposing a significant shift to the lease, such as deciding to rent out only 5 of 7 office spaces, is an illustration of a scope reduction.

Disclosure Requirements for Operating Leases Under ASC 842

ASC 842 includes new disclosure requirements to enable those who use financial statements to evaluate the amount, timing, and unpredictability of cash flows flowing from leases. 

ASC 842 mandates that the reporting of operating lease liabilities as well as lease incentive prospects be included in the lease agreement. Disclosures regarding the operating activities encompass both quantitative and qualitative aspects.

The following provides an outline of accounting for operating leases following ASC 842 at a top standard.

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1. Recognition

• Classification - At the commencement of the lease term, the business is obligated to classify each element of the lease. If the requirements for labeling a lease contract as a finance lease are not satisfied, the lease will be labeled as an operating lease instead.
• Lease modifications - Lease adjustments might result in the revised lease being accounted for as if it were a brand-new, distinct lease. ASC 842 describes the procedure to be followed to establish the appropriate course of treatment.

2. Initial Measurement

• Lease term - It refers to the non-cancellable component of the agreement that consists of a lease, as well as the period during which the opportunity to prolong the lease is accessible. It is viewed as probable that this alternative would be exercised. Similarly, it also includes the portions of the lease where revocation is an option, but it is highly improbable that this choice will be used. And finally, it refers to the segments of the lease where the first two requirements are under the direct authority of the lessor.
• Lease payments - This consists of both fixed and variable lease payments, and ASC 842 provides a detailed definition of each. If the rate implied in the lease is accessible, it should be applied; if it is not, the business should apply its incremental borrowing rate.
• Initial direct costs - These do not include expenditures that could have been incurred in any event, regardless of whether or not the leasing agreement was signed. It covers basic overhead costs, advertising costs, legal and tax assistance, and other professional services.
• Right-of-use asset - During the initial lease liability assessment, the lessee must account for any direct expenses incurred prior to the beginning of the lease, in addition to any lease payments done in advance. It is basically the net value that comes out after factoring in lease incentives. 

3. Subsequent Measurement

• Lease liability and ROU asset - The lease liability is derived from the residual lease payments (current value), and the ROU asset value is calculated by applying the modifications required by ASC 842 to this figure. These elements include prepaid or accrued lease payments.
• Remeasurement - When a lease modification takes place in the context that is described, remeasurement takes place. It can involve either the lease term or the lease payments.

4. Disclosure

• Balance sheet - Segregate the assets and liabilities associated with operational leases (which are categorized as current and noncurrent, just like all other assets and liabilities). Alternatively, determine which items listed in the balance sheet comprise the assets and liabilities associated with the lease liabilities and right-of-use assets.
• Income statement - It comprises the lessee’s expenses.
• Cash flow statement - It includes payments stemming from operating leases. 
• General Disclosure - Qualitative and quantitative details like leases, lease-related payments that have been accounted for in the financial statements, and valuable judgments required when applying ASC 842 to leases must be disclosed.

Switching from FASB ASC 840 to ASC 842 journal entries

Leases are required to be categorized in accordance with FASB standards.

To ensure adequate lessee and lessor accounting compliance, operating leases and capital leases were the two forms of leases recognized by the FASB ASC 840.

As a result of the implementation of ASC 842, capital leases were renamed finance leases. 

An operating lease is considered to be an off-balance-sheet sheet transaction when ASC 840 is applied to it. In the income statement, the rent expense linked with the agreement is accounted for. There is no impact on the balance sheet.

However, in the case of ASC 842, upon the beginning of an operating lease, an ROU asset and an affiliated lease obligation must be recognized.

Accounting systems that have leases classified to be operational according to the FASB ASC 840 can keep the operating lease designation after the adoption of the ASC 842 standard. The FASB ASC 842 criteria must be followed by any leases entered into in the future. 

To be more specific, the most notable change following the new criteria is that all leases (both operating and financing) have to be reported on the company's balance sheet. Journal entries are required to be made for operating leases following the FASB ASC 842 standards.

So, the real question that emerges is that when transitioning from ASC 840 to 842 compliance for the first time, what should the journal entries appear like? 

Ideally, a company's ROU assets and lease liabilities should get reflected in its ASC 842 operating lease journal entries on the transition date if their accounting method accounts for leases by the date of commencement.

After that, utilizing accounting's best practices following ASC 842 will just be part of conducting business as routine. 

Conclusion

While small-to-medium-sized businesses might be equipped to deal with the new guidance transition in spreadsheets, accounting for the adjustments posed by ASC 842 is significantly easier using lease accounting software.

Companies of a certain size should invest in a comprehensive lease accounting software solution to handle all of the company's leases with the help of AI-powered automation to ensure a degree of precision and speed that is unattainable by human means.

Accounting teams must give such solutions a try and figure out the best-fit option.