ASC 842 Income Statement Reporting

Under ASC 842 an operating lease shows as one lease cost within operating expenses. A finance lease splits into amortization and interest (ASC 842-20-25-5, 25-6). The journal entries show the entries behind each.

ASC 842 Compliance and Its Effects on Your Company's Income Statement

The ASC 842 lease accounting standard revolutionizes how companies account for leasing activities, with a significant emphasis on transparency and clarity in financial reporting. While much attention is given to its impact on the balance sheet, it's also important to understand how complying with ASC 842 affects the income statement. This guide aims to demystify the compliance process and outline the changes you can expect on your income statement.

Compliance Essentials with ASC 842

Compliance with ASC 842 requires a company to recognize lease liabilities and Right-of-Use (ROU) assets for almost all lease contracts, fundamentally altering lease accounting practices. Here's a step-by-step approach to ensure your company aligns with these requirements:

Step 1: Identify Your Leases

The first step towards compliance is to conduct a comprehensive review of all your company's contracts to identify which arrangements qualify as leases under ASC 842. This may include traditional leases for office space or equipment, as well as other contracts that might not have been previously classified as leases but now meet the criteria.

Step 2: Classify Your Leases

Under ASC 842, leases are classified as either finance leases or operating leases. This classification affects how leases are reported on the income statement, so it's crucial to understand the criteria for each category.

Step 3: Calculate Lease Liabilities and ROU Assets

For each identified lease, calculate the lease liability as the present value of the lease payments not yet paid (ASC 842-20-30-1(a)). Simultaneously, calculate the ROU asset, typically based on the lease liability, adjusted for prepayments, lease incentives received, or initial direct costs (ASC 842-20-30-5).

Step 4: Record and Report

Adjust your accounting records to include the calculated lease liabilities and ROU assets. Ensure that your financial statements reflect these entries accurately, adhering to the ASC 842 requirements.

Impact on the Income Statement

1. Lease Expense Classification: The distinction between finance leases and operating leases under ASC 842 affects how lease expenses are reported on the income statement. For finance leases, interest on the lease liability and amortization of the ROU asset are recognized separately, impacting both operating income and interest expense. For operating leases, a single lease cost is calculated and recognized on a straight-line basis over the lease term, typically affecting operating expenses.

2. Expense Timing and Recognition: The timing and recognition of expenses may shift under ASC 842. Finance leases will result in a front-loaded expense pattern due to the interest component, while operating leases will see a more even expense recognition over the lease term.

3. Impact on Profitability Metrics: The classification and timing of lease expense recognition under ASC 842 can influence key profitability metrics and ratios reported on the income statement, such as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and operating income.

Where Each Lease Cost Lands on the Income Statement

An operating lease puts one lease cost in income from continuing operations. A finance lease puts amortization and interest where you already show depreciation and interest. The table covers five cost types: operating, finance, short-term, variable and sublease income.

The standard says where an operating lease cost sits in the statement, not which line. It is typically classified, like other expenses, in cost of sales, SG&A or another operating expense line (Deloitte, Roadmap: Leases, 14.2.2.2). The finance lease variable-payment view comes from KPMG's Handbook: Leases, Question 6.9.20. For the full disclosure set, see the ASC 842 disclosure footnote guide.

Operating and Finance Lease Expense on the Income Statement

Operating lease expense is a single lease cost, spread over the remaining lease term on a straight-line basis (ASC 842-20-25-6(a)). The standard allows another systematic and rational basis if it better reflects how the lessee benefits from the asset.

Two things surprise people. First, you do not book interest on an operating lease. The lease liability still accretes, but the single cost, not interest and amortization, is what reaches profit or loss.

Second, the cost does not follow the cash. A lease with rent increases still produces one level cost, and the gap between cost and cash moves the lease liability and right-of-use asset.

Under ASC 840, operating leases were also expensed straight-line, so the income statement for these leases looks familiar. KPMG's Handbook: Leases observes that the short-term exemption is consistent with Topic 840 operating lease accounting. The change is on the balance sheet. For the entries behind each period, see ASC 842 journal entries and the operating versus finance side-by-side.

Finance Lease Expense on the Income Statement

A finance lease produces two charges: amortization of the right-of-use asset and interest on the lease liability (ASC 842-20-25-5(a)). Interest is the amount that produces a constant periodic discount rate on the remaining liability (ASC 842-20-35-1(a)). Amortization is straight-line unless another systematic basis is more representative (ASC 842-20-35-7).

Because interest is highest when the liability is highest, a finance lease costs more in early years than later ones. A lessee presents the two charges like other interest and amortization, and KPMG notes they need not be separate line items (Handbook: Leases, section 6.9.2). The footnote must still break out amortization and interest (ASC 842-20-50-4(a)).

Worked Example: One Lease, Two Classifications

Take a three-year lease with $10,000 payable at the end of each year. Assume a 6% discount rate, no prepayments, incentives or initial direct costs, and no variable payments. The lease liability is the present value of the payments not yet paid (ASC 842-20-30-1(a)): $10,000 × 2.673012 = $26,730.12. The right-of-use asset starts at the same amount (ASC 842-20-30-5).

As an operating lease, total payments of $30,000 spread straight-line give a single lease cost of $10,000 a year. As a finance lease, the asset amortizes straight-line at $8,910.04 a year ($26,730.12 ÷ 3), and interest is 6% of the opening liability.

Both treatments expense $30,000 over the lease, so only timing differs. The finance lease runs about $514 higher in year 1 and about $524 lower in year 3. Year 3 interest is adjusted by $0.01 so the liability ends at zero. The 6% rate is illustrative.

Use the rate implicit in the lease when it is readily determinable, otherwise your incremental borrowing rate. An entity that is not a public business entity may elect, by class of underlying asset, a risk-free rate for a period comparable to the lease term in place of the incremental borrowing rate (ASC 842-20-30-3; KPMG Handbook: Leases, 5.6.30).

Notice what the discount rate did not do to the operating column. With level payments and no adjustments, the single cost is the payments divided by the term. The rate changes the balance sheet and the finance lease split, not the operating expense.

Variable, Short-Term and Impaired Lease Costs

Variable Lease Payments

Variable payments left out of the lease liability are expensed in the period the obligation is incurred, for both lease types (ASC 842-20-25-5(b) and 25-6(b)). Think percentage rent, usage-based fees, or property tax that fluctuates. They sit on top of the single lease cost; they are not spread straight-line.

One timing rule matters. If a payment is triggered by a target the lessee considers probable of being met, the cost is recognized before the target is achieved. It is reversed if the target becomes probable of not being met (ASC 842-20-55-1 and 55-2). See variable payments under ASC 842 for which payments are in the liability.

Short-Term Leases

A lessee may elect, by class of underlying asset, to keep short-term leases off the balance sheet. It recognizes the payments as lease cost straight-line over the lease term (ASC 842-20-25-2). The cost still reaches the income statement and is disclosed, except for leases of one month or less (ASC 842-20-50-4(c)). The short-term lease guide covers eligibility.

Impairment of the Right-of-Use Asset

An impairment of the right-of-use asset is also recognized in profit or loss (ASC 842-20-25-5(c) and 25-6(c)). After an impairment, the single lease cost on an operating lease is calculated differently, as ASC 842-20-25-6(a) points to ASC 842-20-25-7.

Sublease Income on the Income Statement

A company that subleases space it leases is both lessee and lessor. It accounts for the head lease as a lessee and the sublease as a lessor (KPMG, Handbook: Leases, chapter 8). KPMG expects most subleases to be classified as operating leases by the sublessor.

For an operating sublease, the sublessor recognizes the lease payments as income straight-line over the sublease term, unless another systematic basis is more representative (ASC 842-30-25-11(a)). Variable sublease payments are income in the period the underlying facts occur (ASC 842-30-25-11(b)). The head lease expense continues on its own schedule.

Presentation is where practice is split. KPMG states the sublessor generally presents head lease expense separately from sublease income. The footnote requires sublease income on a gross basis, separate from lease expense (ASC 842-20-50-4(e)).

For net presentation, KPMG describes two views and calls either acceptable. One requires gross presentation in all cases. The other allows net only if subleasing is not a significant business activity and exists to manage occupancy cost. PwC (Viewpoint, Financial statement presentation guide, 14.3.2.3) and Deloitte (Roadmap: Leases, 14.3.1.2.1) also accept net presentation only in narrow cases.

Check this one with your auditor early. KPMG also notes one limit. If the sublessor is not relieved of its primary obligation under the head lease, netting the head lease and sublease on the balance sheet is never appropriate. For the commercial side, see sublease strategy under ASC 842.

Lease Income When You Are the Lessor

Most of this page is lessee accounting, but some searches are for lease income. A lessor with an operating lease recognizes lease payments as income straight-line over the lease term, unless another systematic basis is more representative (ASC 842-30-25-11(a)). Because income is straight-lined, it differs from cash rent when rents step up (ASC 842-30-25-11(a)). Variable payments are income when the facts they depend on occur (ASC 842-30-25-11(b)).

Initial direct costs are expensed over the lease term on the same basis as the lease income (ASC 842-30-25-11(c)). Sales-type and direct financing leases follow a different, interest-based model. See lessee versus lessor under ASC 842.

What Lease Accounting Does to EBITDA and Operating Income

Classification decides the effect. Operating lease cost stays in operating expense, so it reduces both operating income and EBITDA. Finance lease amortization and interest sit in the lines EBITDA adds back, so a finance lease lifts EBITDA.

In the example above, year 1 operating income is lower by $10,000 under the operating treatment. Under the finance treatment it is lower by the $8,910.04 amortization, with $1,603.81 of interest below operating income, assuming both are presented in the usual lines. Net income differs only by timing.

If a loan covenant uses EBITDA, read the credit agreement's definition. Definitions vary, so do not assume the reported figure is the covenant figure. Our article on EBITDA-based covenants under ASC 842 covers this. For cash flow effects, see the cash flow statement page, and for the other side of the entry, the balance sheet page.

The Short Version

An operating lease lands as one straight-line cost within operating expenses. A finance lease lands as amortization plus interest, with the charge highest in the early years. Short-term lease payments are straight-line cost, variable payments are expensed when incurred, and sublease income is disclosed gross (ASC 842-20-50-4(e)).

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