Our lease accounting series includes a comprehensive breakdown of implementation considerations, including:
- Lease tracking solution (Excel vs. lease software)
- Resources needed to implement and maintain
- Identifying the lease portfolio
- Evaluating the lease agreements and overall scope
- Calculating the lease obligations and right of use assets
- Financial reporting and disclosures
- Internal control processes going forward
In this article, we continue the lease accounting series by evaluating lease agreements and calculating lease obligations and right of use assets. Evaluating these items can be one of the trickier parts based on the nuances of the lease standard. In the most recent article, we discussed tips on how to identify the lease portfolio. The considerations below may be done in conjunction with gathering the information.
Evaluating the lease agreements and overall scope
When evaluating your lease portfolio all three of the following conditions must exist to be a lease:
- An identified asset exists
- The lessee has the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use
- The lessee has the right to direct how and for what purpose the identified asset is used throughout the period of use
Once you have determined if your agreement constitutes a lease, there is additional information needed to calculate the right of use asset and obligation including the following:
- What term should be used?
- When is the date of control? (i.e. Under 842 classification starts at lease commencement)
- Should renewal options be included?
- Is there a variable rent component to include? (For example, CPI adjustments or Percentage Rent)
- What non-lease components are fixed?
- Are multiples units included in the lease payment (e.g., equipment)?
The lease standard does provide for relief under certain practical expedients. The first three must be adopted on an “all or nothing” approach. The remaining items may be chosen independently.
- No reassessment of lease classification for existing leases.
- No reevaluation of existing/expired contracts for embedded leases.
- No reassessment of previously recorded initial direct costs.
- Hindsight expedient (lease terms, options, etc.)
- Combination of lease and non-lease components (i.e. fixed lease payments excluding executory costs such as CAM, insurance, etc.)
- Permitted to use a risk-free interest rate if there is no discount rate implicit in a lease contract
- Land easement expedient
Calculating the lease obligations and right of use assets
Under ASC 842, initial operating lease liabilities and finance lease liabilities are calculated using the exact same method.
- Calculate the lease obligation value as the present value of future remaining lease payments and policies elected above
- Calculate the right of use asset which starts with the lease obligation value adjusted for the following upon implementation:
- Prepaid rent
- Accrued rent
- Lease incentives
- Tenant Improvement allowances
- Unamortized initial direct costs (IDC)
- Deferred rent
- Closed store reserve
As detailed above, there are nuances to the lease standard when calculating right of use assets and lease obligation liabilities; therefore, working with a professional such as a CPA provides management another resource for technical knowledge.
If you would like to talk through your approach, your GBQ team is here for you.
Article written by:
Kristen Romaker, CPA
Manager, Assurance & Business Advisory Services