Operating Lease Example

 

FAS 13/IAS 17 Methodology

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Operating Example: Office Lease

Let's take as an example an office lease, for a portion of an office building. It lasts for ten years. The first 5 years, the rent is $5,000 per month; the second five years, the rent increases to $6,000 per month. There is also a clause to pass through any increase in property taxes that may occur.

In many cases, the "fair value" of a portion of a building is not easily determinable. If this is true, FAS 13 allows you to skip the present value test [FAS 13, para. 28]. Such leases will, as a rule, never convey ownership, so the only test left to determine whether the lease is capital is whether the lease term is 75% or more 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.
 
If there were no change in the rents, the rental payments would simply be expensed as incurred, making very simple accounting (though the future rent commitment of all leases needs to be disclosed). Since this lease has a scheduled rent increase, which does not reflect a change in the availability of the asset (for example, an increase in the space covered by the lease), FASB Technical Bulletin 85-3 (FTB 85-3) requires the rent to be recognized on a straight-line basis over the life of the lease, with a deferred liability that accounts for the difference between cash rent paid and accrued rent expense. (A lessor also straight-lines the rent, recognizing a deferred asset.) 
 
 
 Monthly journal entry (first 5 years)
 
 Operating rent expense
5,500.00
  
     Deferred liability  
500.00
     Cash  
5,000.00
 
Monthly journal entry (second 5 years)
 
 Operating rent expense
5,500.00
  
 Deferred liability
500.00
 
     Cash  
6,000.00

 

Note: At the end of the life of the lease, the deferred liability will be zero. If a lease is terminated early, you recognize a gain equal to the balance in the deferred liability account (because rent that you have expensed will not actually need to be paid). Any termination penalty is an offsetting loss.

In some cases, governmental entities need not level the rent as shown above. Under Governmental Accounting Standard #13 (GAS 13), rents may be expensed as incurred, even when they change during the life of the lease, "when the pattern of the payment requirements, including the increases, is systematic and rational." Increases in the rent due to actual or anticipated inflation are specifically listed as qualifying examples. In such cases, no deferred asset or liability is recognized; each month, operating rent expense is debited and cash is credited for the actual rent payment. (Note that the governmental lease accounting standard is currently in revision, with a new standard expected to be implemented in 2020.)

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. (Future rent commitment disclosure is based on cash, not accrual, rent.) So as of the end of year 1, your disclosure would be:

 

The following is a schedule by years of minimum future rentals on noncancelable operating leases as of December 31, 20X8:

 
 Year ending December 31,
 
   20X9:
60,000
   20X0:
60,000
   20X1:
60,000
   20X2:
60,000
   20X3:
72,000
 Later years:
288,000
 Total minimum future payments required:
600,000

 

 

 

 

 

 

 

 

 

 

 

 

 

To enter this lease in the trial version of EZLease, follow these steps:

  • Enter a Begin Date (such as January 1, 2010)
  • Double-click on the Lease Term; in the box that appears, enter 120 (or enter an end date that makes the lease term 120 months exactly, which will be one day earlier in the year than the begin date, such as December 31, 2019)
  • Set the Classification According To to FAS 13 (or IAS 17, if you have set EZLease to IFRS accounting).
  • Leave Classification as "To be classified" and Capital Rate blank, so EZLease can determine it
  • Click on the Main data tab, if it is not already present
  • Enter Gross Rent on the first line of 5000
  • Enter a Step End date 5 years after the begin date (such as Dec. 31, 2014)
  • On the second rent line, enter Gross Rent of 6000; the Step End date matching the end of the lease does not need to be changed
  • Enter Economic Life of 360 (30 years)
  • Click on the Inception tab
  • Check the box that reads Fair Value Not Determinable
  • Click Save. The classification is updated to Operating.

     

 

A Reliable, Tested Solution

EZLease is our PC-based application for lessees (with a separate version for lessor accounting), implementing our 40 years of experience in lease accounting software.
 
 
See also our examples of capital/finance lease accounting for FAS 13/IAS 17 and for ASC 842/IFRS 16.
 

 

Also test out our Asset Retirement Obligations reporting in the trial version of either EZLease or EZ ARO

 

Download Here

 

 

 

 

ASC 842/IFRS 16 Methodology

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Operating leases under IFRS 16

IFRS 16 does not have an official "operating" category for leases. However, there are two exceptions to the general rule that all leases are finance:

  1. A lease with a total lease term, including available options (even if not considered reasonably certain of exercise), of 12 months or less.
  2. A lease of a "low value" asset (defined by the IASB as an asset which, when new, would have a fair value of less than approximately US$5,000.

Such leases are excluded from normal IFRS 16 reporting; they do not have to be shown on the balance sheet, and are simply expensed on a straight-line basis, like IAS 17 operating leases are.

Existing IAS 17 leases which do not fall under these exclusions are capitalized according to the remaining rent at transition to IFRS 16.

Operating Example: Office Lease (ASC 842)

Let's take as an example an office lease, for a portion of an office building. It lasts for ten years. The first 5 years, the rent is $5,000 per month; the second five years, the rent increases to $6,000 per month. There is also a clause to pass through any increase in property taxes that may occur. No services are provided with the lease. The current cost of a commercial mortgage for 10 years is 4%.
 

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, never convey ownership, so the only test left to determine whether the lease is capital is whether the lease term is 75% or more 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.
 
The lease is capitalized at the incremental borrowing rate of 4%.
 
Sample finance lease journal entries, first month:
 
Account Debit Credit
 Right-of-use asset

540,116.39

  
     Current liability  
40,974.66
     Long term liability  
499,141.73
 (Initial booking)    
 Current liability
3,216.28
  
Operating lease cost 5,500.00  
     Cash  
5,000.00
     Accumulated depreciation  
3,716.28
 (Monthly rent payment)    
 Long term liability
3,336.19
  
     Current liability  
3,336.19
 (Liability reclassification, long term to current)    


The accumulated depreciation activity for the period is calculated as the sum of change in liability (rent paid of 5,000, minus 1,783.72 interest accrued) plus the 500 difference between cash and straight-line rent. If a lease has initial direct costs or lease incentives to amortize, those are also included in the asset and the calculation of the depreciation. Depreciation and interest are not expensed directly, but only within the "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. So as of the end of year 1, your disclosure would be:

 

The following is a schedule by years of minimum future rentals on noncancelable operating leases as of December 31, 20X8:

 

 Year ending December 31,
 
   20X9:
60,000
   20X0:
60,000
   20X1:
60,000
   20X2:
60,000
   20X3:
72,000
 Later years:
288,000
 Total minimum future payments required:
600,000
    Less imputed interest 99,194
Net present value of future lease payments 500,806

 

 

 

 

 

 

 

 

 

 

 

 

 

To enter this lease in the trial version of EZLease, follow these steps:

  • Enter a Begin Date (such as January 1, 2017; needs to be on or after the ASC 842 transition date as specified in System Options, New Standard tab)
  • Double-click on the Lease Term; in the box that appears, enter 120 (or enter an end date that makes the lease term 120 months exactly, which will be one day earlier in the year than the begin date, such as December 31, 2026)
  • Set the Classification According To to ASC 842. (Under IFRS 16, this lease will be finance.)
  • Leave Classification as "To be classified" and Capital Rate blank, so EZLease can determine it
  • Click on the Main data tab, if it is not already present
  • Enter Gross Rent on the first line of 5000
  • Enter a Step End date 5 years after the begin date (such as Dec. 31, 2021)
  • On the second rent line, enter Gross Rent of 6000; the Step End date matching the end of the lease does not need to be changed
  • Enter Economic Life of 360 (30 years)
  • Click on the Inception tab
  • Check the box that reads Fair Value Not Determinable
  • Click Save. The classification is updated to Operating.

     

 

A Reliable, Tested Solution

EZLease is our PC-based application for lessees (with a separate version for lessor/sublease accounting), implementing our 40 years of experience in lease accounting software.
 

See also our examples of finance (capital) lease accounting for FAS 13/IAS 17 and for ASC 842/IFRS 16.

 
 

 

Also test out our Asset Retirement Obligations reporting in the trial version of either EZLease or EZ ARO

 

Download Here