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7 Absolute Facts about Type B leases under the New Lease Accounting Rules
In a previous post, I explained Type A leases under the proposed new lease accounting rules in detail. This blog post summarizes – in plain English – Type B leases under the proposed lease accounting rules.
Type B leases = Operating Leases: Under the new lease accounting rules, operating leases will now be called Type B leases. The way to distinguish between Type A (Capital) and Type B (Operating) leases remain largely unchanged, except that the FASB eliminated the bright–lines in the rules, that is, the 75% of lease term and 90% of FMV rules are no longer hard and fast, primarily because the board is moving away from “rules” based accounting to “principle” based accounting.
For Most Leases, the ROU Asset and the Lease Liability Will Be Equal Upon Lease Commencement: If you have a Type B lease without initial direct costs, prepaid rent, and without a tenant improvement allowance (or some other lease incentive), then the ROU asset and the lease liability will be equal on the lease commencement date. The entry will simply be a debit to the ROU asset and a credit to the lease liability. This is the same for Type A leases. Click here for a summary of Type A leases under the new proposed lease accounting rules.
Initial Lease Liability Calculation: The initial Lease Liability for Type B leases under the new lease accounting rules is calculated as the present value of the minimum lease payments discounted using the borrowing rate of the lessee. To learn how to use excel to calculate the present value of minimum lease payments, click here. Please note that the initial lease liability for Type B leases is calculated in the EXACT same way as the initial lease liability for Type A leases. However, unlike Type A leases, the lease liability for Type B leases is NOT considered debt.
Initial ROU Asset Calculation: The initial ROU (Right of Use) asset for Type B leases under the new lease accounting rules is the initial lease liability as calculated above, plus any prepaid lease payments and initial direct costs, less any lease incentives (for instance, tenant improvement allowances) received prior to the lease commencement date. Please note that the initial ROU Asset calculation for Type B leases is calculated in the EXACT same way as the initial ROU Asset calculation for Type A leases. Click here for a summary of Type A leases under the new proposed lease accounting rules.
Subsequent Lease Liability Calculation: Subsequent values of the lease liability are determined via accretion using the effective interest method, similar to other financial liability. Like any other loan amortization schedule, a portion of the payments each period goes to liability reduction, and the remainder goes to lease expense. Please note that UNLIKE Type A leases, where a portion of the payments goes to debit interest expense, under Type B leases lease (or rent) expense is debited. That said, while the subsequent lease liability calculations are the same under Type A and Type B leases, the entries made are different (Type A requires an entry to Interest Expense, while Type B requires an entry to Rent Expense). Click here for a summary of Type A leases under the new proposed lease accounting rules.
Subsequent ROU Asset Calculation: The ROU asset is amortized as the difference between “average rent” and lease (or rent) expense from the liability. Average rent is simply straight line rent expense under today’s rules for operating leases. Note that unlike Type A leases, the amortization of the ROU asset for Type B leases is NOT deemed depreciation expense. Just like the amortization of the liability under Type B leases, it is also called “Lease (or Rent) Expense.” As a result, rent expense for Type B leases is recorded on a single line item for Type B leases; but a portion comes from the liability and the other piece comes from the ROU asset. The total effect on the income statement is “average rent,” which is the same effect operating leases have on the income statement under current GAAP.
There is NO CHANGE when comparing effects of Type B leases and Operating Leases on the Income Statement, EBITDA and Debt: Operating leases are currently amortized via straight-line on the income statement. Under the new rules, Type B leases will also be amortized straight-line, via “average rent,” which means there is no change to the income statement under Type B rules versus operating leases today. In addition, under Type B leases, amortization of the lease liability and the ROU asset are NOT considered interest expense or depreciation expense respectively, and as a result EBITDA is not affected under Type B leases versus operating leases today. Finally, the lease liability resulting from Type B leases is not considered debt, which means debt is also unchanged when comparing Type B leases to operating leases today. The chart above is a simplified diagram summarizing the effect of Type A and Type B leases on Net Income, EBITDA, Debt and the Balance Sheet.
There you have it. That’s basically a summary of Type B leases per the new lease accounting rules. Click here for a summary of Type A leases. In a subsequent post, I will give a comprehensive example of a Type B lease under the new lease accounting rules using actual numbers.
About LeaseQuery: LeaseQuery is lease accounting 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. Visit us at www.LeaseQuery.com