ASC 842 Operating Lease Example

Operating leases
The FASB decided to adopt a dual lessee accounting model, classifying leases in a similar manner to the previous requirements in US Generally Accepted Accounting Principles (US GAAP) for distinguishing between operating leases and capital leases, and to account for those two types of leases differently.

Under IFRS 16 there is a single accounting model for leases which is described under the Capital/Finance lease example. There are no Operating leases under IFRS 16.

There are 5 criteria that, if any one is met, the lease would qualify as a finance lease. If none are met, the lease would qualify as an operating lease.

  1. Transfer of ownership
  2. Purchase option that is reasonably certain to be exercised
  3. The lease term is greater than a major part of the remaining economic life of the asset
  4. PV of the lease payments (plus residual value) is equal to or exceeds substantially all of the fair value 
  5. Asset of a specialized nature

Let’s take as an example an office lease for a portion of an office building. It lasts for ten years and rent is due on the first day of each month. The first 5 years, the rent is $5,000 per month; the second five years, the rent increases to $6,000 per month. No services are provided with the lease. The current cost of a commercial mortgage for 10 years is 4%

FASB 13/IAS 17 - Operating lease example: Office lease

In many cases, the “fair value” of a portion of a building is not easily determinable, because a part of a commercial building is rarely available for sale. If this is true, you may skip the present value test. Such leases will, as a rule, never convey ownership, so the only test left to determine whether the lease is finance is whether the lease term is 75% or more of the economic life. A building is typically assigned a life of 20 years or more, so this lease’s 10-year term is considerably less than 75%, and the lease is considered operating.

Debit Credit
Initial booking
Right-of-use asset
Current liability
Long-term liability
Monthly rent payment
Current liability
Operating lease cost
Accumulated depreciation
Liability reclassification, long term to current
Long term liability
Current liability
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The accumulated depreciation activity for the period is calculated as the sum of change in liability (rent paid of 5,000.00 less effective interest of 1,783.72) plus the 500 difference between cash and straight-line rent. If a lease has initial direct costs or lease incentives to amortize, those are also included in the asset and the calculation of the depreciation. Depreciation and interest are not expensed directly, but only within the “operating lease cost.”

You also need to disclose your future rent commitments. At the end of the first year, for example, you have four years of $5000 per month rent remaining, plus five years of $6000 per month. So as of the end of year 1, your disclosure would be:

The following is a schedule by years of minimum future rentals on noncancelable operating leases as of December 31, 2021:

Year ending December 31,
Later years
Total minimum future payments required
Less imputed interest
Net present value of future lease payments

To enter this lease in EZLease, follow these steps* :

*Assumes default system settings of an Implementation Date of 1/1/2019 and a 12/31 Year End.

ASC 842 Operating lease example

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Capital/Finance leases

Capital/Finance leases

Capital/Finance leases

Operating leases