Almost all agreements are reported on the balance sheet in accordance with ASC 842 lease standards. This prerequisite frequently raises the following queries: How much of the lease liability do we record?

How much of the leasing asset do we record? Data gathering is the most difficult part of recording the right-of-use assets and lease liabilities. It is crucial to confirm the correctness of the rental term, the lease payment, and that the amount of the discount is based on solid facts before recording the lease liability. Likewise, it's critical to account for early direct expenditures, prepayments, and leasing incentives before recognizing the right-of-use asset.

Combining this data is a simple process once it is obtained. Let's examine the process step-by-step for recording the right-of-use asset and related lease liabilities.

What is the Right-of-use Asset?

An asset that symbolizes a lessee's right to use a borrowed item for the length of the prearranged lease term is known as a right-of-use resource, or ROU asset in lease accounting. Stated differently, the lessee is authorized to reap the financial rewards associated with using an asset that belongs to a different party. This asset is known as the "lease asset" under GASB 87.

Leasing Liability: What is it?

A lease liability is an adequately called cost to make the payments deriving from a lease, calculated on a discounted basis, as per three key standards (GASB 87, IFRS 16, and ASC 842). An asset with a right of use under ASC 842. Because it continues to use a dual-model method to show lease liabilities and assets on the income statement and balance sheets, ASC 842 deviates from IFRS 16.

Stated differently, ASC 842 maintains its distinction between operational and financing leases, with a capitalized ROU asset being necessary for each kind of lease. Nonetheless, compared to ASC 840, the accounting treatment of finance leasespreviously known as capital leasesunder ASC 842 is substantially the same. Lessees of capital leases had to report an asset and a liability under the previous standard. Under ASC 842, this is also accurate.

How does ASC 842 Compute the Right-of-use Asset?

The same technique is used to determine the initial operating and financing lease ROU assets under ASC 842. In order to account for any lease payments given to the lessor at or before starting, less the incentives won and any initial direct expenditures borne by the lessee start from the initial cost of the lease liability, which is calculated by depreciating the remaining lease payments. Expressed as the following formula:

First-time lease obligation

+ Unpaid remaining amount of rent in advance

- Total amount of unpaid postponed rent

What Documentation of Lease Obligation is Required?

We must be aware of these three elements in order to reflect lease obligations on the balance sheet:

• Establish the duration of the lease. Sometimes, determining the length of a lease takes discretion, especially if the contract includes options for renewal and termination.
• Check the amount paid for the lease. In certain situationssuch as when one has payments associated with choices for renewal or terminationdetermining the rent payment also calls for judgment.
• Understand the rate at which the lease liability will be discounted. We must ensure that the inputs used to calculate the additive borrowing rate are trustworthy if we want to use it.

In order to determine the right-of-use asset, what is required? We are documenting the right to employ the asset (such as the right to use a vehicle) rather than the physical asset itself with the right to use asset (ROU asset), which is an intangible asset. Before determining the proper value for the right-of-use asset, we must take into account the following three factors:

• First-time direct expenses (bearing by the tenant)
• Lease incentives (which the lessee receives)
• Prepayments for the lease (paid by the lessee)
• First-party expenses

The definition of first direct costs is as follows:

Additional expenses associated with a lease that shouldn't have been incurred in the absence of the lease. For instance, paying a lawyer to get legal or tax advice is probably not going to be considered an upfront expense. However, since a broker's commission is paid only after the lease is acquired, paying the broker would probably be considered an initial direct expense.

Similarly, paying a current renter to end the lease would probably be considered an upfront, direct cost (remember, this expense would only be payable if the license had been acquired).

Amortization of Right-of-use Assets

Operating leases must amortize the right-of-use asset differently from financing leases, per ASC 842. When an operational lease is in place, the liability lease expenditure is deducted from the overall lease expense to determine the methodical and sensible amortization of the right-of-use asset. Assets under finance leases are amortized linearly.

Additionally, according to ASC 842, operational lease ROU resources must be amortized from the date of the lease commencementwhich is when the lessee takes ownership of the underlying assetuntil the end of the lease period. It could, under some circumstances, be from the asset's start date until the end of its useful life. This also applies to financing leases as defined by GASB 87, IFRS 16, and ASC 842.

The amount owed, discounted to present value, for the payments stipulated in the lease is known as a lease liability. The current worth of the payments on the lease that are still owed throughout the lease period is used to determine the finance lease obligation under ASC842, IFRS16, and GASB 87.

According to each of the four primary lease standards, the discount rate inherent in the lease should be used. In some situations where a hidden interest rate cannot be ascertained, each standard does permit the use of an annual borrowing rate that is specified by the standard.

The Bottom Line!

Whichever lease accounting principle is used, at the time of transition both a right-to-use commodity and a lease liability will be recognized on the balance sheet.

Each guideline has a specific definition of what constitutes a reportable lease and what factors go into the calculations, so reporting entities need to understand the underlying financial statement presentation as well as the methodologies used to compute the ROU asset and associated lease obligations.