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ASC 842 Cash Flow Statement Example – a Quick Guide

ASC 842 Cash Flow Statement Example - a Quick Guide Featured Image

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The introduction of ASC 842 has significantly shifted financial reporting for leases, particularly in financial statements disclosure, including the cash flow statement presentation. Preparing cash flow has always been challenging, but ASC 842 adds further complexity to the process. 

The purpose of this article is to provide a simplified example for quick understanding when a brief overview is needed. Whether you are a lease accountant or involved in financial reporting, we hope this guide will help clarify the ASC 842 impact on the cash flow statement.

Classifying the Type of Leases under ASC 842

Before diving into the cash flow statement example, we need to ensure that the leases are appropriately classified under the guidelines of ASC 842, as the classification determines how these leases are reflected in the cash flow statement. Here is a quick recap: 

Finance Lease vs. Operating Lease

A lease is classified as a finance lease if it meets at least one of the following criteria. If it does not meet any of these criteria, it is classified as an operating lease.

  • Ownership will transfer at the end of the lease.
  • The lessee has the option to purchase the asset at the end of the lease.
  • The lease meets the “75%” economic life rule.
  • The lease meets the “90%” present value of payment rule.
  • The asset has been customized for the lessee’s use.

Short-term Lease Exemption

ASC 842 offers an optional exemption for leases with a term of 12 months or less. If the lessee elects to apply this exemption, they do not need to apply the ASC 842 treatment of recognizing the ROU asset or lease liability. See here for more details, and we will discuss the impact on the cash flow statement below.

ASC 842 Cash Flow Statement Example – Operating Lease

Generally speaking, operating lease payments are classified as operating activities. Pretty self-explanatory.

The only exception is when the payment serves as a cost to bring another asset to its intended use, such as leasing space to build equipment; it should be classified as an investing activity.

Scenario: Pho My Life (PML) Noodle Shops has entered a 3-year operating lease for kitchen equipment. During their 1st year, they incurred the following:

  • They made a lease payment of $10,000
  • The reduction to the lease liability and the depreciation of ROU assets are both $8,638.
  • They also made $100,000 in food revenue and spent $50,000 on ingredients.

Direct Method

ASC 842 Cash Flow Statement Example - Operating Lease Direct Method

The direct method starts with the cash receipt, which is $100,000. Afterward, we record two lines of cash expenditures: $50,000 for ingredients and $10,000 for the operating lease expense. As a result, the total cash inflow from operating activities is $40,000 ($100,000 Revenue – $50,000 Ingredients – $10,000 Lease Payment). Note that ROU asset depreciation and reduction in lease liability are ignored as they are accrual-based items. The direct method is based on the cash basis instead of the accrual basis.

Indirect Method

ASC 842 Cash Flow Statement Example - Operating Lease Indirect Method

The indirect method starts with the net income from the business, and then a reconciliation from net income to cash balance is performed.

  • Net Income: $40,000. ($100,000 Food Revenue – $50,000 Ingredients – $10,000 Operating Lease Expense)
  • Reduction in Lease Liability: ($8,638), given in the example. A reduction in lease liability is considered a “change in net operating assets and liabilities.” Hence, it was subtracted to calculate net cash flow using the indirect method. 
  • Depreciation: $8,638, which is also given in the example. Depreciation & Amortization are added back to calculate cash balance in the indirect method, as they reduce net income but have no cash impact. As a result, it’s added back or shown as a positive number.
  • Net Cash Flow: $40,000 (The two reconciliation items netted zero)

It’s important to understand that when using the indirect method to account for operating leases, sometimes there’s no net effect after all, as the depreciation of the Right-of-Use (ROU) asset and the decrease in lease liabilities tend to offset each other. This scenario is common in operating leases with straightforward structures, where lease payments consistently match the lease cost. However, when there are differences between lease payments and lease costs, such as in free rent periods, the indirect method would accurately reflect these nuances and display the correct cash balance in the cash flow statements.

ASC 842 Cash Flow Statement Example – Finance Lease

Per the guidance, finance leases are slightly more complicated, as the interest portion of the lease payment is classified as operating activities. In contrast, the principal portion of the lease payment is grouped under financing activities.

Scenario: Pho My Life (PML) Noodle Shops has entered a 3-year finance lease for kitchen equipment. During their 1st year, they incurred the following:

  • They made a lease payment of $10,000
  • The interest expense: $2,487
  • The amortization of ROU assets: $8,290
  • They also made $100,000 in food revenue and spent $50,000 on ingredients.

Direct Method

ASC 842 Cash Flow Statement Example - Finance Lease Direct Method

The direct method starts with the cash receipt, which is $100,000. We then record the expenditure of $50,000 on ingredients. In a finance lease, only the interest portion of the lease payment is recorded in operating activities, which is $2,487 in this example. As a result, the total cash inflow from operating activities is $47,513 ($100,000 Food Revenue – $50,000 Ingredients – $10,000 Lease Payment). 

As for the principal portion of the lease payment, it is recorded under financing activities. Since the cash payment is $10,000, the principal portion comes out to be $7,513 ($10,000 cash payment – $2,487 interest portion). 

In the end, the net cash inflow for PML Noodle Shops is $40,000 ($47,513 operating activities – $7,513 financing activities)

Indirect Method

ASC 842 Cash Flow Statement Example - Finance Lease Indirect Method

The indirect method starts with the net income from the business, and then a reconciliation from net income to cash balance is performed.

  • Net Income: $39,223. ($100,000 Food Revenue – $50,000 Ingredients – $2,487 Interest Expense – $8,290 Depreciation Expense)
  • Depreciation: $8,290, which is given in the example. Depreciation & Amortization are added back to calculate net cash flow in the indirect method, as they reduce net income but have no cash impact. As a result, it’s added back or shown as a positive number.
  • Cash Provided from Operating Activities: $47,513. Only the interest portion of the lease payment is classified as operating activities. However, the interest is not a reconciliation item as it’s not part of the lease liability. Therefore, the net cash flow from operating activities is $47,513 ($39,223 Net Income + $8,290 Depreciation Add-back)
  • Financing Activities – Reduction in Lease liability: $7,513. Only the principal portion of the lease payment is classified under financing activities. Since the cash payment is $10,000, the principal portion comes out to be $7,513 ($10,000 cash payment – $2,487 interest portion). 
  • Net Cash Flow: $40,000 ($47,513 from Operating Activities – $7,513 from Financing Activities)

Right-of-use (ROU) Asset Cash Flow Statement Example

Right-of-use (ROU) assets are an important element introduced in the ASC 842 lease accounting standard. Various scenarios can lead to adjustments in ROU assets, with the initial recognition being the most common one. Here is a quick guide and example of how the Right-of-use assets are presented on the cash flow statement.

Per the guidance, changes made to the right-of-use (ROU) assets are classified as non-cash items, which need to be disclosed as supplemental items on the financial statement. However, this supplemental disclosure can be made either in the cash flow statement or in a footnote per ASC 230.

In reality, many large public companies choose to disclose this information in their footnotes. Here are some examples:

Microsoft 10-K (Annual Report) for the FY ended June 30, 2023.

ASC 842 Cash Flow Statement Example - right of use ROU asset Microsoft

In Footnote 14, Microsoft called out “Right-of-use assets obtained in exchange for lease obligations”, and further bifurcated the numbers into operating leases and finance leases as part of the supplemental cash flow disclosure.

Walmart 10-K (Annual Report) for the FY ended January 31, 2023

ASC 842 Cash Flow Statement Example - right of use ROU asset Walmart

In Footnote 7, Walmart also listed two lines: “Assets obtained in exchange for operating lease obligations” and “Assets obtained in exchange for finance lease obligations” within the cash flow table of the lease footnote.

Apple 10-K (Annual Report) for the FY ended September 30, 2023

ASC 842 Cash Flow Statement Example - right of use ROU asset Apple

Similarly, Apple disclosed the non-cash item in a paragraph in Footnote 8 listing activities involving “right-of-use (“ROU”) assets obtained in exchange for lease liabilities,” which fulfilled the supplemental cash flow disclosure requirement.

To conclude, adjustments made to right-of-use (ROU) assets are treated as non-cash items, which are commonly disclosed in the footnote disclosure.

Other Types of Lease Costs

Here is a list of how the other kinds of lease costs are classified on the cash flow statement:

  • Variable lease payments not included in lease liability: such as insurance premium, common area maintenance, etc. – Operating Activities
  • Short-term leases: leases that are exempt from ASC 842 treatment (see here for details) – Operating Activities
  • Initial direct costs: incremental costs necessary for the lease to be signed – Investing Activities (the justification is that it’s related to onboarding the ROU asset)
  • Prepayments/Prepaid Rent: similar to the initial direct costs, it’s related to onboarding the ROU asset (technically, the prepaid rent is added to the ROU asset balance as well – see here for details) – Investing Activities

Key Takeaways

  • Operating Lease: lease payments for operating leases are typically classified as operating activities.
  • Finance Lease: lease payments for finance leases are bifurcated into two portions. The interest portion is classified as operating activities, and the principal portion is classified as financing activities.
  • Right-of-use (ROU asset) acquisition/adjustments: non-cash items disclosed either in the cash flow statement or separately in the footnote disclosure.
  • Short-term lease and Variable lease payment (excluded from the calculation of lease liability) are operating activities.
  • Initial direct costs are investing activities.
  • Prepayment/Prepaid Rent are investing activities.

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