Last week’s blog focused on one important thing: How to calculate the present value of lease payments using excel spreadsheets. This week, we will show you how to calculate the present value of minimum lease payments AND prepare the liability amortization schedule for the lease liability in the same step, using excel. Let us stress that this information is important not just for companies that plan on continuing to use excel spreadsheets for lease management. It is also a useful tool for those of you that plan on using lease accounting and lease management software, as you can use the information in this blog to ensure that your chosen software provider is actually performing this calculation accurately. So basically, with the method we explain below, you will have everything you need to comply with the new lease rules powered only by an excel spreadsheet. Next week’s blog will feature a comprehensive example of how to transition from current lease accounting rules to the new lease accounting standards, and we will be referencing the methods utilized in this blog for our calculations. For now, here are the steps to follow to calculate the present value of lease payments AND the lease liability amortization schedule using excel, when the payment amounts are different.
About LeaseQuery: LeaseQuery is lease management software that helps companies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A. Contact us here.
FASB/IASB lease accounting “Divergence.” Far from converging, the FASB and IASB have decided to take different routes concerning lease accounting. While both boards decided to capitalize all leases on the balance sheet, the FASB decided to allow companies to use one of two methods to expense the capitalized assets and liabilities: Accelerated Expense Method (called Type A Leases in the Exposure Draft) or Straight line expense method (Type B). The method used depends on if the asset qualifies as an operating lease versus a capital lease under current accounting guidelines. Capital leases would be treated as Type A leases, while operating leases would be considered Type B.
The IASB, on the other hand, has elected to require all companies to use the Accelerated Expense Method for all leases.
The boards stress that they will continue to work together to prepare a converged solution, however this is a very significant difference in approaches.
In their continuing deliberations, the accounting boards are now considering three different approaches to lease accounting. The first approach would basically retain the Type A–Type B model as proposed in the Exposure Draft – Type A for leases of personal property and Type B for leases of real property (land and buildings).
The second approach being considered is a single model, in which lessees would account for all leases as they would for Type A leases. Under this scenario Type B leases would be eliminated.
The third approach being considered would still utilize Type A and Type B leases, however the dividing line would no longer be the type of asset as proposed in the exposure draft. Rather, we would return to the current GAAP distinction between capital and operating leases, albeit now including all leases on the balance sheet. Lessees would account for most capital leases as Type A leases and for most operating leases as Type B leases.
In this post I will explain Type A leases in detail from the lessee perspective. We will discuss how to calculate the initial and subsequent values of the lease liability and the initial and subsequent values of the Right of Use (ROU) Asset. In a later blog we will discuss how lessees will address the transition from leases that are classified as operating leases under current GAAP to Type A leases under the lease exposure draft.
Example 1: Entity A (Lessee) enters into a 10 year lease of equipment with payments of $10,000/yr in years 1 through 5, and $15,000/yr in years 6 through 10. Assume that the lessee’s incremental borrowing rate is 6%, and payments are made in advance. Assume the useful life of the equipment is 20 years, and the fair value is $150,000.
Analysis of Example 1: The first thing to notice here is that the underlying asset in this lease is Equipment, which is personal property. Recall from our previous post that leases of personal property are classified as Type A leases unless:
1) the lease term is insignificant compared to the total economic life of the asset, or
2) the present value of the minimum lease payments is insignificant compared to the fair value of underlying asset.
The lease term is 50% of the useful life of the asset. This is not insignificant. The present value of the minimum lease payments is $94,700. (This is how the present value of the mimimum lease payments was calculated). This is over 60% of the fair value of the equipment, which is not an insignificant amount.
Because the exceptions in 1) and 2) above are not met, this is a Type A lease.
On the lease commencement date (not the execution date), company would record the ROU asset and the Lease Liability. The entry would be a debit to the ROU asset and a credit to the lease liability for the present value of the minimum lease payments, as follows:
Dr. ROU Asset 94,700
Cr. Lease Liability 94,700 To record ROU asset and Lease liability at commencement.
The ROU asset would be depreciated straight-line, so each year the following entry will be made:
Dr. Depreciation Expense 9,470
Cr. Accumulated Depreciation ROU Asset 9,470 To record amortization of ROU asset at year end.
The Lease Liability would be amortized using the effective interest method according to the following table:
The cash column represents the cash paid, the expense is the interest rate times the previous month’s liability balance, the liability reduction is the difference between the cash and the expense, while the liability balance is the difference between the previous month’s liability balance and the liability reduction.
Based on the table above, the following entry would be made to represent the first month’s payment:
Dr. Lease Liability 10,000
Cr. Cash 10,000 To record first lease payment.
Note that the first payment has no interest expense recorded. This is because interest is a function of time, and if a payment is made at the beginning of the lease term then no time has passed for interest to accrue. As such, the entire payment goes against the principal. The entry to record the second lease payment will be as follows:
Dr. Interest Expense 5,082
Dr. Lease Liability 4,918
Cr. Cash 10,000 To record second lease payment.
Notice that after year 10, the lease liability will be at zero, and the lease asset would be fully amortized. Also notice that the expense associated with the lease hits the income statement twice; once as amortization (depreciation expense) of the ROU asset, and another as interest expense from the lease liability. As a result, rather than having rent expense evenly recorded through the lease term (as is currently the case with operating leases), the expense is “front loaded,” meaning that there is greater expense recorded in the earlier years of the lease term than in the latter years.
Now that we have covered Type A leases, I will move on to explain Type B leases in a separate post. I will also cover transition guidance from current GAAP to Type A leases in another post.