The new lease accounting standard is effective for private companies and nonprofits for fiscal years beginning after December 15, 2021. This new accounting rule requires organizations to report their operating leases on the balance sheet. This will require some new journal entries. Is your organization ready?
To help accounting teams at businesses and nonprofits, here are some of the basic journal entries you’ll need to use to account for operating leases under the new lease standard.
1. Recognize the lease liability and right of use asset (ROU) on the balance sheet at the commencement of the lease for new leases or upon transition to ASC 842 for existing leases
- Lease liability = the present value of the future unpaid lease payments (The future lease payments should be discounted at the rate implicit in the lease, or if unknown, the lessee can use the lessee’s incremental borrowing rate. Private companies and nonprofits also have the option to use a risk-free rate as the discount rate.)
- Right of use asset = lease liability + initial direct costs to obtain the lease + any prepaid lease payments – any lease incentives received
Example: Lessee leases a piece of equipment. The lease term is three years and the lease payments are $75,000 for year 1, $80,000 for year 2, and $85,000 for year 3, due at the end of each year, respectively. The lessee uses its 6% incremental borrowing rate as the discount rate to calculate the lease liability.
Initial journal entry to record lease
Debit the ROU account and credit the lease liability account
Lease liability $213,322
- Upon transitioning to ASC 842, in addition to recording the amount calculated above, if the entity has a deferred rent balance, accrued rent balance or an unamortized lease incentive liability balance on the balance sheet from leases previously accounted for under ASC 840, then they should remove the deferred rent/accrued rent/lease incentive liability balance through the ROU account
2. Post subsequent entries for each reporting period to recognize the lease payment made, the interest accrued on the lease liability, and the amortization of the ROU
- Lease expense is recognized on a straight-line basis over the lease term
- Accrue interest on the balance of the lease liability each period
- Amortize the ROU (this amount will be the difference between the straight-line lease expense and interest component recorded each period)
- Using the example from above, here is the journal entry to post at the end of year 1:
Debit lease expense ratable each period over the term of the lease, debit lease liability for the amount of the lease payment made for the period less the interest accrued on the lease liability balance for the period (calculated accrued interest of $12,799 for year 1), credit the ROU for the amortization amount for the period (difference between the straight-line lease expense and interest component recorded each period), credit cash for the amount of the lease payment made for the period
Lease expense $80,000
Lease liability $62,201
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