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Lease Accounting Operating vs Financing Leases, Examples

journal entry
definition of lease

Conveniently, all three standards provide exemptions for short-term leases — those shorter than 12 months. The lessee determined that the lease at inception was a finance lease due the fact that the lease term exceeded 75 percent of the economic life of the asset. Its incremental borrowing rate at inception was 5 percent and it used that rate to calculate the lease liability as $216,474. As illustrated in the above example, accounting for leases classified as operating can be quite complex as contrasted with the current model. Although the rent expense running through the income statement is the same, the need to account for the balance sheet accounts over the term of the lease requires additional calculations and entries to be made each period. Assume an entity enters into a lease of office space for a period of five years with annual lease payments of $100,000 payable at the beginning of the year.


To repurchase the asset precludes sale treatment unless the option is at fair value and the subject asset is essentially a commodity. Nonetheless, financial statement preparers for organizations in complicated leasing arrangements may have difficulty applying these provisions. In-depth analysis, examples and insights to give you an advantage in understanding the requirements and implications of financial reporting issues.

Lease modification considerations

Any prepaid rents, lease incentives, and initial direct costs should be rolled up into the ROU asset. The new lease accounting standards are complex of necessity, to capture the challenging and dynamic nature of the underlying agreements. Therefore, reporting on assets and liabilities is extremely difficult without software. It’s measured by taking the lease liability and adding the initial direct costs and the prepaid lease payments, then subtracting any lease incentives offered . In summary, the three standards are mostly consistent regarding lease definitions and various terminology. However, ASC 842 takes a dual approach to accounting treatment, while IFRS 16 and GASB 87 both use a single approach.

For a modification that is not a separate lease, the lessee’s accounting depends on the nature of the modification. If a lease modification creates a separate lease, the lessee makes no adjustments to the original lease and accounts for the separate lease the same as any new lease. A comparison of the income statement and balance sheet impact under the two alternative policy choices is below. To calculate the adjustment to the lease liability, Lessee Corp would compare the recalculated and original lease liability balances on the modification date.

Commensurate with the reduction in leased space, the annual lease payment will be reduced from $100,000 a year to $50,000 a year. Lessee Corp is also required to pay Lessor Corp a one-time termination penalty of $30,000 along with its next lease payment. The accounting for terminations and partial terminations is the most complex area when calculating the values of the lease liability and right of use asset.

This date is also used to determine the appropriate incremental borrowing rate, which is utilized to discount the future lease payments recorded on the balance sheet as a lease liability. The possession date is sometimes the same as the commencement date, but can also fall after, or even before. When there is a reduction in the lease term, the lessee remeasures the lease liability based on the future lease payments; the balancing journal entry goes to the right of use asset. The IASB decided that under IFRS 16, a reduction in the lease term does warrant a gain/loss calculation. In order to do so, many entities may need to use off system spreadsheets, as the legacy enterprise resource planning systems may not be able to handle such entries automatically. This will, of course, require attention to internal control over financial reporting .

This will align with $0 lease payments as of the cease use date. Without knowing more details of the specific agreement and transaction, I am wondering why cash is mmissing from the journal entry. If the decision for termination was made in advance of the termination itself, then the lease liability and ROU asset will need to be recalculated. Because there are various options to terminate a lease, it’s important to understand the accounting treatment of an early termination under the respective new standard.

Changing the lease term after initial lease entry

The lease states that the annual payment increases each year based on the increase in the Consumer Price Index . The interest rate implicit in the lease is not readily determinable, so the entity uses its incremental borrowing rate, which is 8 percent, to discount the cash flows. Expense will be recognized on a straight-line basis for an operating lease.


Generally, the payments used to determine lease classification will be the same as used for the initial measurement. Except, residual value payments are included for the purpose of lease classification but excluded for the lease liability calculation unless they are probable of being paid. The accounting by organizations that own the assets leased by the lessee—also known as lessor accounting—will remain largely unchanged from current GAAP.

Approach 2: proportionate change in the remaining ROU asset

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Lessee Corp has historically accounted for the lease of 100,000 square feet as one lease component. Lessee Corp has previously made an accounting policy election to calculate the reduction in the right-of-use asset in proportion to the reduction to the right of use (i.e., decrease in leased space). Assume that any additional right of use, the original contract, and the modified contract meet the definition of a lease. Remeasure the lease liability and right of use asset based on the modified lease payments. The lessee would update the lease liability and right of use asset based of the future cash flows at a point in time. Question LG 5-6 discusses the accounting by a lessor for a termination penalty paid by a lessee due to a modification of two leases between them with immediate exit of one property by the lessee at the lease modification date.

The date new information is known triggers an update to the lease term and/or lease payments and is also the date the lease term should be recalculated. If a lessee elects to use the short-term lease expedient, the leases are treated as if ASC 842 had never been applied and the lessee will recognize lease payments as straight-line expenses for the duration of the lease contract. Reasonably certain is interpreted as a high possibility that an event will or will not occur. An entity that is reasonably certain whether they will exercise or not exercise a renewal or termination option at the commencement of the lease has weighed the outcomes and made a decision based on the facts and circumstances of the agreement at the time. The lessee reviews various economic factors to assess if they are reasonably certain to exercise or not to exercise an option. Some of those factors are based on the contract, underlying asset, market, and entity.

Lessor Accounting

profit and loss statement classification is determined, and the lease is recognized and measured, at the lease commencement date. Rather than making a significant payment to a landlord to cancel a lease, tenants may be inclined to sell or sublease their lease to another lessee. This would first be predicated by a lease agreement permitting such sale/sublease or a landlord otherwise agreeing to it.

Cardiovascular : The Nasdaq Stock Market LLC – Form 8-K –

Cardiovascular : The Nasdaq Stock Market LLC – Form 8-K.

Posted: Thu, 13 Apr 2023 13:26:53 GMT [source]

As IFRS 16 requires all lessee leases to be classified as finance leases, the calculations would be applied to the lease liability and ROU asset of a finance lease, not an operating lease as shown above. As mentioned above, we split the journal entry for this approach into two steps for clarity. To calculate the new ROU asset after modification, the lease asset before modification ($24,630,474) would be decreased by the proportionate adjustment to the ROU asset ($9,852,190) and then increased as a result of the updated lease terms ($1,957,788). The difference between the proportionate reduction of the lease liability ($10,835,992) and the proportionate reduction of the ROU asset ($9,852,190) is recognized as a gain on termination. Now let’s assume in January of 2026, the lessee and lessor amend the original terms of the lease to only include 3 floors of the office space.

If a lessee continues to use the asset or a portion of the asset for a period time after the lease termination is agreed upon, the termination should be accounted for as a lease modification based on the modified lease term . IFRS 16 requires the calculation of a modified lease liability, and an adjustment to the asset value to reflect the partial termination with any variance recorded to gain or loss in the current period. LeaseGuru powered by LeaseQuery can provide these calculations needed for IFRS 16 compliance. After calculating the modified lease liability, the lessee should adjust the right-of-use asset value by a proportionate amount.

The impact will depend on a few factors, including whether the vacated floor is a result of a new contract/terms agreed upon by you and the landlord, or whether it’s based on an internal decision. If the floor is terminated as a result of new terms, then you should follow guidance for a partial termination. If the floor is abandoned as a result of an internal decision, then you should assess whether the floor qualifies as a separate lease component. If it’s determined it’s not a separate component, there will be no change in the accounting, but if it is a separate component, then the portion that is abandoned would be amortized through the cease use date.

The notes to financial statements should include a description of leasing arrangements and the total amount of inflows of resources recognized from leases. Taxpayers frequently enter into leases to guarantee access to a particular asset at a fixed price. In such cases a taxpayer can either continue the lease or try to terminate it. If the lessor is paid a cancellation fee, the law allows the taxpayer to deduct that fee because it does not create a substantial future benefit. The correct tax treatment of the purchase price recently came before the courts. As we debit the lease liability account with the principal payment each year, its balance reduces until it reaches zero at the end of the lease term.

Costs to terminate these nonlease components should continue to be accounted for under ASC , even after the adoption of ASC 842. If the new contract is a lease or contains an embedded lease, the new lease should be accounted for as any other new lease . See LG 3 for information on lease classification and LG 4 for information on lease measurement. If the lease modification does not create a separate lease, the accounting depends on how the lease would have been classified had the modified terms been in effect at the inception date. The sections below highlight five phases of adopting ASC 842, including key activities that an entity may perform and factors it may consider to gauge how much time and effort it will take to complete certain steps in the transition process. Although implementation strategies vary, we developed these recommendations on the basis of experiences with public-company implementation.


In the accrual method of accounting, this is the amount of interest incurred on debt during a particular period of time and appearing as a separate line on a company’s income statement for the period cited. The interest expense is also used, along with depreciation, when a lease is capitalized and posted as an asset on the balance sheet. A Lease Accounting Disclosure report provides the required values for quantitative reporting as prescribed by the latest lease accounting standards. It includes sections for lease expense, other information including ROU assets obtained in exchange for lease liabilities, and maturity analysis. When you transition existing leases to the new standard, you need to reclassify capital lease assets and capital lease liability as ROU assets and lease liabilities .

  • The agreement states that Company L will lease five floors of a building for office space at $6,000,000 per year increasing by 3% over a period of 10 years.
  • A lease modification is a change to the contractual terms and conditions of a lease that was not part of the original lease.
  • Assume a private company, Company L, enters into an operating lease agreement commencing on January 1, 2020 – the date the company plans to early adopt the new lease accounting standard.
  • The lessee determined that the lease at inception was a finance lease due the fact that the lease term exceeded 75 percent of the economic life of the asset.
  • Leasing assets is a common practice for companies of all sizes and industries.

Like with any modification, the lessee is required to update the discount rate at the date effective. In this example, the original terms of the agreement state that the lessee will lease five floors. This can be taken at face value whereby the lessee would simply calculate the change in the number of floors they have access to or the lessee can determine the square footage of each floor and then calculate the change. Under IFRS 16, all lessee leases are classified as finance leases, which will not require lessees to perform any analysis of the five criteria outlined above.