Transitioning to FASB ASC Topic 842, Leases presents first-time adopters with many qualitative and quantitative challenges. A common challenge in the final stages of transitioning to the new standard is how to account for legacy deferred rent liabilities that were required under FASB ASC Topic 840.
You may recall that lessees with operating leases containing escalating rent payment schedules are required to recognize rent expense on a straight-line basis, necessitating a deferred rent liability (accrued rent) for the imbalance between actual cash payments and straight-line rent expense. After assisting clients with multiple transition projects, we are often asked the question, “What do I need to do with my deferred rent accounts?”
On the transition date to FASB ASC Topic 842, a lessee measures an operating right-of-use asset at an amount equal to the lease liability, adjusted for prepaid or accrued rent, the remaining balance of any lease incentives, unamortized initial direct costs and any impairment. The starting point for the measurement of the right-of-use asset is the lease liability, which is calculated as the present value of lease payments, including fixed payments less any lease incentives, such as tenant improvement allowances, paid or payable to the lessee. After determining the lease liability, you begin the right-of-use asset measurement by determining the lease liability value and then adjusting for prepaid rent, accrued rent, lease incentives, initial direct costs and impairment. It is common for the lease liability to not match the right-of-use asset at the adoption date due to these adjustments.
A simplified example illustrates the journal entries necessary to account for an existing deferred rent liability at transition. In this example, an entity has a lease contract for an office building with annual rent increases of 2%. Under legacy lease accounting, the entity has appropriately accounted for the lease rent expense on a straight-line basis and recognized a lease liability throughout the term of the lease. On the transition date to FASB ASC Topic 842, the balance of the deferred rent liability is $100,000. After analyzing the terms and provisions of the contract, the entity calculates a $1,500,000 FASB ASC Topic 842 operating lease liability. There are no lease incentives or initial direct costs. The journal entry to record the lease is as follows:
Example 1
| Debit | Credit | |
|---|---|---|
| Operating right-of-use asset | $1,500,000 | |
| Deferred rent liability | $100,000 | |
| Operating right-of-use asset | $100,000 | |
| Lease liability | $1,500,000 |
If the entity did not previously recognize a deferred rent liability under legacy lease accounting in this example, the journal entry at transition would be as follows:
Example 2
| Debit | Credit | |
|---|---|---|
| Operating right-of-use asset | $1,400,000 | |
| Retained earnings | $100,000 | |
| Lease liability | $1,500,000 |
The debit to retained earnings in Example 2 represents a catch-up adjustment of expense that should have been recognized in prior periods. Many organizations that had not correctly accounted for operating leases under legacy guidance will have an adjustment similar to Example 2.
Organizations need to find a suitable solution for calculating the FASB ASC Topic 842 right-of-use assets and lease liabilities at the transition date and the subsequent lease accounting. Generally, an Excel-based solution would be appropriate for a noncomplex portfolio of 10 or fewer leases. If the lease profile is more complex or greater than 10 individual leases, management is better served by a lease software solution, such as simpLEASE. In addition to offering our clients simpLEASE, Schneider Downs provides advisory services for the technical aspects of lease accounting. For more information concerning lease accounting and the impact on your organization, please visit the Schneider Downs Our Thoughts On blog or email us at [email protected].
