When the changes in an accounting standard impact assets or liabilities, we are accustomed to the difference flowing through equity. The new lease standard, ASC 842, is different because equity is not typically impacted in the initial journal entries. It might seem strange to not use your trusty “Cumulative Effect of a Change in Accounting Principle” account when implementing a new standard, yet it’s true – and important to know to ensure that your lease assets and liabilities are properly recorded. So how does it work? Read on to learn more.
Assets, liabilities, and equity
When transitioning leases from ASC 840 to ASC 842, you need to start by calculating your lease liability, which is the present value of all future lease payments after the Initial Application Date. That includes monthly rents, known escalators, and residual value guarantees.
Next, you remove existing lease balances, such as deferred rent for an operating lease or a capital lease’s asset and liability. As you reverse these balances off the books, they should flow through the Right of Use (ROU) asset—not through your equity balances as is common when implementing a new accounting standard.
For most cases, your ROU asset is the lease liability, plus or minus the differences of those existing balances. As a result, it is rare that equity is affected when implementing the new lease standard.
Note: As with most rules, there are exceptions where equity will actually be affected, depending on policy elections and other scenarios. You’ll find a list of exceptions in this guide.
Missteps to avoid
Because your lease transition and initial journal entries for ASC 842 differ from most accounting standard changes, there are some missteps you should avoid.
- You might be tempted to have your ROU asset and liability match and remove your existing balance through an equity account. Instead, any existing balances should be reversed out through the ROU asset.
- The asset could be potentially different if you have existing balances related to that lease on your books either as an asset or liability. You need to reverse those balances because they were under the old standard. The full difference of those flows through the ROU asset.
- Keep in mind that the liability is the “stake in the sand” as the present value of your future lease payments; the liability is based on what you actually owe. Changes should be made through the ROU asset.
Here are some excellent resources on transitioning leases under the new standard:
- Transitioning to the New Lease Standard (With Sample Journal Entries)
- Lease Review Checklists for Office Space and Vehicle Leases
Although this is a fairly straightforward aspect of the new standard, spreadsheets become risky as soon as you have more than a half-dozen leases. GBQ is pleased to partner with lease accounting software LeaseCrunch to simplify your adoption efforts. To learn more, contact Kristin Romaker or Mary Stucke.