The Debits and Credits of the New Lease Accounting Standards

A high percentage of GAAP-basis financial statements will be impacted by the new lease accounting standards. With the standards going into effect for calendar year end 2022 for nonpublic entities, now is the time to understand and prepare for the changes.

This article will provide an overview of the accounting for an operating lease under the new standards, show an example of what an entity’s balance sheet will look like after adoption, illustrate how an often looked at financial ratio will be impacted, and provide details of the additional footnote disclosures that will be required.

Below is an illustration of the debits and credits an entity will need to make to account for the change in lease standards.

Operating lease example fact pattern:
Lease description: office space lease
Term: 10 years (no renewal option)
Commencement date: January 1, 2022
Monthly payment: $100,000 (no escalations) due last day of each month
Entity’s incremental borrowing rate: 4%

Balance sheet recognition. Amounts are calculated based on the present value of an ordinary annuity of $100,000 per month at 4% for 10 years.

Lease Expense: $100,000 (monthly payment); Lease Liability – accreted interest on $9,877,467 at 4%; Right-of-Use Asset: $67,526 - represents the amount needed to get the entry to balance.

Notes: The monthly lease expense will remain consistent at $100,000; the monthly lease liability adjustment will decrease each subsequent month as it is based on the unamortized amount of the lease liability at the entity’s incremental borrowing rate, the right-of-use asset monthly adjustment will increase due to the reduction in the lease liability adjustment (entry needs to balance).

If an entity chooses to record the adjustments at the end of the year (assuming this is the entity’s reporting date), the adjustment would be as follows:

Note: It is assumed with each $100,000 monthly lease payment the entity made had debited the lease liability account and credited its cash account for $100,000

Using the above fact pattern, the impact of the adjustments above (regardless of the frequency) will leave the Right-of-Use Asset and Lease Liability balances at the same amount. What should be noted is the Lease Liability balance will have a current and a long-term component as shown on the hypothetical balance sheet below.

PJ10 Inc.
Balance Sheet
December 31, 2022 

The impact of the adoption of the new lease accounting standards on certain financial ratios (i.e., current ratio) is highlighted when looking at the above example whereby PJ10 Inc.’s current ratio will decrease from 2.70 to 2.05 due to the adoption of the new lease accounting standards.

Above are the basics for how the new lease accounting standards work and use a simplified fact pattern which is not likely to exist in most operating leases. Additional typical lease characteristics such as initial direct costs, lease incentives and escalating payments will add some complexity to the computations. At a high level, treatment of the more common lease characteristics under the new lease accounting standards will be treated as follows: initial direct costs are included as part of the lease cost, and thus they would be amortized on a straight-line basis. Likewise, lease incentives (“free” rent period or build-out allowances) and variable lease payments will also be amortized on a straight-line basis. The impact of these lease provisions will be that the lease expense will no longer be the same as the operating cash flows related to the lease, and the right-of-use asset and lease liability would no longer be equal at the end of each period (as was the case using the simplified fact pattern).

Upon adoption of the new lease accounting standards, the additional footnote disclosures will expand from the current requirements to include, but are not limited to, the following:

• The determination of the discount rate for the lease
• Weighted average of remaining lease term
• Weighted average discount rate
• Maturity analysis showing the undiscounted cash flows on an annual basis for a minimum of the first five years and a total of the amounts for the remaining years and showing a reconciliation of the undiscounted cash flows to the lease liabilities recognized on the entity’s balance sheet.
  
  

Should you need assistance in preparing, implementing, or discussing best practices leading up to your entity’s adoption of the new lease accounting standards, please reach out to your Citrin Cooperman advisor. We are here to help.