Question

You are Adam Rogers, CPA. The VP of one of your clients, Relient Corporation, emailed you the following message:

Adam,

I was at a conference today and they were talking about some new lease regulations and how that may impact our financial statements. I know that we have a couple of leases, one that we record as a liability and one that we do not. How will this new lease requirement impact us? When does this go into effect? Will we need to restate prior financial statements? Are there any retrospective entries that we have to make? If so, what are they and when do we need to record them? They also talked about adopting early. I may be interested in early adoption. What would we need to do to implement this change this year?

Upon investigation of Relients’s records, you found that Relient had had two leases. One that is currently being accounted for as a capital lease and one being treated as an operating lease (under current standards).

The capital lease was for equipment. The lease started in 2016 and was a 5-year lease of annual lease payments of $50,000, starting on January 1, 2016. The lease also had a bargain purchase option for $20,000 at the end of the lease. The equipment had a useful life of 6 years and Relient uses the straight-line method of depreciation. The implicit interest rate for this lease was 6%.

The operating lease was a 15-year lease for their facilities that started on January 1, 2015. The lease consisted of annual rental payments, starting on January 1, 2015, of $60,000. When they started the lease in 2015, the expected useful life of the facility was 30 years. Relient imputed interest rate is 8%.

My question is listed below!

1. Assuming adoption in 2018, what are the new year-end (December 31, 2018) adjusting entries that will need to be made?

Answer 1

ASC 842 suggests a modified retrospective transition. Hence we would need to pass adjusting journals to give the impact of the change in accounting.

With the new lease standard ASC 842, All leases having a term of more than 12 months would require recording of an Asset - Right-of-use and a Lease Liability. Hence

Capital Lease

The accounting for capital leases is mostly the same, except for the change in certain terminology. This would not require an adjusting entry

Operating Lease

Under the Old Accounting Standards we would have recorded expenses of 60000 for every year from 2015 to 2017. The Accumalated profits would include expenses of $60,000 X 3 = $180,000. No Depreciation Would have been charged in the above method.

Under the new accounting standards, a company is required to record an asset and a liability even for operating leases.

The first step is to compute the present value fo the Minimum Lease Payments
The Present Value of a 15 Year lease of $60,000 per year at the beginning of the year, at 8% is

PV = 60000 + (60000X(1-(1+8%)^-14)/8% = $554,654

We would need to record an asset and liability for this under the new method:

Adjusting Entry 1	Debit	Credit
Right-to-Use Asset	554,654
Lease Laibility		554,654

This asset would be amortized over the 15 years based on the interest expense.

A lease expense of $60,000 would be recognized immediately on the first payments. For the next 14 payments the following is the amortization schedule:

	A	B	C	D	E
Year	Outstanding Liability	Annual Expense	Interest Component (A X 8%)	Amortization Component (B-C)	Lease Expense (B)
2016	4,94,654	60,000	39,572	20,428	60,000
2017	4,74,227	60,000	37,938	22,062	60,000
2018	4,52,165	60,000	36,173	23,827	60,000
2019	4,28,338	60,000	34,267	25,733	60,000
2020	4,02,605	60,000	32,208	27,792	60,000
2021	3,74,813	60,000	29,985	30,015	60,000
2022	3,44,798	60,000	27,584	32,416	60,000
2023	3,12,382	60,000	24,991	35,009	60,000
2024	2,77,373	60,000	22,190	37,810	60,000
2025	2,39,563	60,000	19,165	40,835	60,000
2026	1,98,728	60,000	15,898	44,102	60,000
2027	1,54,626	60,000	12,370	47,630	60,000
2028	1,06,996	60,000	8,560	51,440	60,000
2029	55,556	60,000	4,444	55,556	60,000

The Total Lease Expense to be recognized in years 2015, 2016 and 2017 are:

$60,000 + $60,000 + $60,000. This would not require any adjustment.

However, under the new method an amortization expense also needs to be recognized for the 3 years, amounting to :

=0 + 20,428 + 22,062 = 42,490. Hence the Asset and Lease Liability needs to be amortized to this extend:

This would require the following entry

Adjusting Entry 2	Debit	Credit
Lease Liability	42,490
Right-to-Use		42,490