ASC 842 Operating Lease Example

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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.

Of the following five criteria, if any one is met, the lease would be classified as a finance lease. If none are met, the lease would be classified as an operating lease.

  1. Automatic transfer of ownership at the end of the lease.
  2. Purchase option that is reasonably certain to be exercised.
  3. The lease term is substantially all of the remaining economic life of the underlying asset.
  4. Present value (PV) of the lease payments (including any contractual obligation at the end of the lease) represents substantially all of the fair value of the underlying asset.
  5. The asset is of a specialized nature.

Operating lease example

Let’s take, as an example, an office lease which starts on 1/1/2022 for a portion of an office building. It lasts for ten years and rent is due on the first day of each month. For 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, not 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 (75% is almost universally used as a threshold for “substantially all” 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. Since this is not a short-term lease (12 months or less), the lease must be reported on the balance sheet with a right-of-use asset and liability which is the PV of the rental payments of $540,116.39.

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Debit Credit
Initial capitalization
Operating right-of-use asset
Operating current liability
Operating long-term liability
Monthly rent payment
Operating current liability
Operating lease cost
Operating accumulated amortization
Liability reclassification, long-term to current
Operating long-term liability
Operating current liability
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The accumulated amortization activity for the period is calculated as the sum of change in liability (rent paid of $5,000 less effective interest of $1,783.72) and the difference between cash and straight-line rent ($500). If a lease has initial direct costs or lease incentives to amortize, those are also included in the asset and are amortized straight line over the lease term. Amortization and interest are not expensed explicitly but bundled together as “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.

The following is a schedule by years of minimum future rentals on noncancelable operating leases as of December 31, 2022

Year ending December 31, 2022
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 1/1/2022 and a 12/31 Year End.

ASC 842 operating lease example

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Capital/Finance leases

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Operating leases

Capital/Finance leases

Capital/Finance leases

Operating leases