Lease Accounting Balance Sheet Example: Understanding the Impact of ASC 842

Lease accounting has undergone significant changes with the adoption of ASC 842. This new standard requires lease liabilities to be reported on the balance sheet, which has a substantial impact on financial statements. In this blog post, we will explore the true impact of lease liabilities on the balance sheet and provide practical examples to help you understand the implications.

Lease Liabilities – The Impact on your Balance Sheet

The inclusion of lease liabilities on the balance sheet provides a more accurate representation of a company's financial position. Previously, operating leases were kept off-balance sheet, which could distort the true financial health of an organization. With ASC 842, all lease liabilities must be recognized, resulting in increased liabilities and a corresponding increase in assets.

To illustrate this impact, let's consider an example. Company XYZ has entered into a lease agreement for office space. Under the old accounting standards, this lease would not have been recorded on the balance sheet. However, under ASC 842, Company XYZ must recognize the lease liability and corresponding right-of-use asset.

About the ROU Asset

The right-of-use (ROU) asset represents the lessee's right to use the leased asset over the lease term. It is calculated as the present value of lease payments, discounted using the appropriate discount rate. The ROU asset is then amortized over the lease term, resulting in a reduction of the asset value over time.

Monthly Changes Under ASC 842

ASC 842 requires lessees to reassess lease liabilities on a monthly basis. This means that any changes in lease terms, lease payments, or discount rates must be reflected in the balance sheet. For example, if Company XYZ negotiates a lease extension or modifies the lease payment terms, the lease liability and corresponding ROU asset must be adjusted accordingly.

Determining the Discount Rate for Calculating Present Value

The discount rate used to calculate the present value of lease payments is a key component of lease accounting under ASC 842. The discount rate should reflect the lessee's incremental borrowing rate, which is the rate the lessee would have to pay to borrow funds to purchase the leased asset. It takes into account factors such as credit risk, term of the lease, and the lessee's financial condition.

Impairment of ROU Assets and Lease Liabilities

Under ASC 842, lessees must assess the impairment of ROU assets and lease liabilities if events or circumstances indicate a potential impairment. Impairment occurs when the carrying amount of the asset exceeds its recoverable amount. Recoverable amount is the higher of the asset's fair value less costs of disposal or its value in use.

Lease Liabilities and EBITDA

The inclusion of lease liabilities on the balance sheet can impact a company's EBITDA (earnings before interest, taxes, depreciation, and amortization) calculation. EBITDA is a measure of a company's operating performance and is often used by investors and analysts to evaluate profitability. As lease liabilities increase, EBITDA may decrease, as lease payments are classified as interest expense and amortization of the ROU asset.

New Standards, New Reporting Processes

The adoption of ASC 842 requires organizations to implement new reporting processes to ensure compliance. Companies must gather accurate lease information, evaluate lease terms, calculate lease liabilities and ROU assets, and make ongoing adjustments as necessary. This requires collaboration between finance, accounting, and real estate teams to ensure accurate and timely reporting.

Putting it all together to record lease liability and right-of-use asset

Recording lease liabilities and right-of-use assets involves several steps:

• Gather lease information, including lease term, lease payment, and discount rate.
• Calculate the present value of lease payments using the appropriate discount rate.
• Record the lease liability on the balance sheet as a long-term liability.
• Calculate the right-of-use asset as the present value of lease payments.
• Amortize the right-of-use asset over the lease term.

Lease liability reminders

When recording lease liabilities, it is important to consider:

• Tax and accounting regions
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Practical Illustrations of the New Leasing Standard for Lessees

The implementation of the new leasing standard (IFRS 16) has brought significant changes to lease accounting. This standard, issued by the IASB, aims to provide a converged standard on leasing. Let's explore some practical illustrations to understand how this new standard impacts lessee accounting for finance and operating leases.

Background

The development of a converged standard on leasing took nearly 10 years, culminating in the issuance of IFRS 16. This standard replaces the previous guidance on lease accounting (SFAS 13) and introduces a more consistent approach to lease recognition and measurement.

The Flaws in SFAS 13

The previous lease accounting standard (SFAS 13) had several flaws that led to inconsistencies in reporting. One of the major issues was the off-balance sheet treatment of operating leases, which resulted in a lack of transparency and distorted financial statements.

The Catalyst for Change

The flaws in SFAS 13 and the need for greater transparency in lease accounting were the catalysts for developing a new standard. The goal was to provide users of financial statements with a clearer picture of a company's leasing activities and their impact on financial performance.

The New Standard

IFRS 16 introduces a single lessee accounting model that requires lessees to recognize most leases on the balance sheet. This eliminates the distinction between finance leases and operating leases, which existed under the previous standard. As a result, lessees are required to recognize a lease liability and a corresponding right-of-use asset for almost all leases.

Lessee Accounting for Finance and Operating Leases

Under IFRS 16, lessees are required to recognize lease liabilities and right-of-use assets for both finance leases and operating leases. This is a significant change from the previous standard, where only finance leases were recognized on the balance sheet.

Illustrations

To better understand the impact of IFRS 16, let's consider some practical illustrations:

Balance sheet

The balance sheet now reflects lease liabilities and right-of-use assets for both finance leases and operating leases. This provides a more accurate representation of a company's financial position and increases transparency.

Income statement

Under IFRS 16, the distinction between operating and finance leases is no longer relevant for lessees. Instead, lessees are required to recognize a depreciation expense for the right-of-use asset and an interest expense for the lease liability. This results in higher expenses in the early years of the lease term.

Statement of cash flows

The statement of cash flows is also impacted by the new leasing standard. Cash payments for lease liabilities are classified as financing activities, while payments for interest expense can be classified as either operating or financing activities.

Transitioning to the New Standard

Transitioning to the new leasing standard requires careful planning and consideration. Companies need to assess the impact on their financial statements, implement new processes and systems, and educate stakeholders about the changes. It is important to consult with accounting professionals and auditors to ensure compliance with the new standard.

Conclusion

The new leasing standard (IFRS 16) and ASC 842 have significantly changed lease accounting. The inclusion of lease liabilities on the balance sheet provides a more accurate representation of a company's financial position and increases transparency. Understanding the impact of these changes is crucial for financial reporting and decision-making. By following the guidelines provided in this blog post and seeking professional advice, organizations can navigate the complexities of lease accounting and ensure compliance with the new standards.