ASC 842 introduced many complexities in the lease accounting treatment, including lease extensions and renewals, which are common business activities. Essential for both lessees and lessors, these extensions can significantly impact financial statements. In this article, we will provide a practical example with journal entries and step-by-step guidance to help you better understand lease extensions and renewals under ASC 842.
Lease Extensions & Renewals under ASC 842
A lease extension or renewal under ASC 842 occurs when the lessee and lessor agree to extend the lease term beyond the originally stipulated period. This extension must be formalized in an agreement or contract with a specific effective date, as timing is crucial for the accounting treatment.
Effective Date Before the Original Contract’s Expiration
When the extension/renewal contract becomes effective before the original contract expires, a remeasurement must be performed per the guidance of ASC 842-10-25-8. This situation cannot be treated as a separate new contract, as that would require the inclusion of additional ‘right-of-use assets,’ like extra space or equipment. Merely extending the period of use of the original asset does not grant any additional “rights.”
What is a Remeasurement? In simple words, the right-of-use (ROU) asset and lease liability must be “revalued” using the discount rate and the remaining lease payments as of the modification date. Further analysis, including the classification of leases and allocation of consideration, will also be reviewed and reassessed.
The critical factor is the date of modification or the effective date mentioned in the extension or renewal agreement. For example, suppose the original lease is due to expire in December, but the extension or renewal agreement was signed and became effective in October. As a result, the revaluation of the right-of-use (ROU) asset and liability should be recognized in October using the discount rate applicable at that time. Delaying the recording of this renewal until December does not align with the rules for lease remeasurement outlined in ASC 842.
Effective Date After the Original Contract’s Expiration
On the other hand, if the effective date of the renewal/extension occurs after the original lease expires, then no remeasurement is needed. In this case, the renewed lease should be treated as a new contract, with its initial recognition occurring on the effective date of the renewal.
Month-to-Month/Short-term Lease Extension
Month-to-month or Short-term lease extensions may be subject to more straightforward accounting treatment if they satisfy the “Short-term lease” definition outlined by FASB. These leases can omit recognizing the right-of-use (ROU) asset and lease liability. Instead, the rent payment is recorded as an operating expense.
We have an article that explains this treatment in detail: Month-To-Month Lease Under ASC 842 – a Simple Guide.
Lease Extension & Renewal Journal Entry Example
Let’s present a simplified, real-world scenario to further illustrate how the accounting treatment or the journal entries are calculated and recorded for lease extension & renewal under ASC 842:
- Pho My Life (PML) Noodle Shop, the lessee, has a lease agreement for an oven with Oven Leasing Company, the lessor.
- The original lease term expires on December 31st, 2024.
- The PML Noodle Shop decides to extend the lease before the original lease ends. The lease extension agreement is signed and becomes effective on October 1st, 2024.
- As of October 1st, 2024, the PML Noodle Shop has an existing right-of-use (ROU) asset and lease liability totaling $5,000 associated with this specific oven lease.
- Extension period: 24 months (October 2024 to October 2026)
- Monthly Lease Payments: $1,000
- Discount rate: 4% as of October 1st, 2024
- All other terms stay the same (lease classification etc.)
Step 1: Calculate the Present Value of Lease Payments
By applying the PV formula or using the PV calculator, it is concluded that the Present Value of the $1,000 monthly payment for 24 months at a 4% rate (0.33% monthly) is $23,028. This will become the “new” lease liability as well as the right-of-use (ROU) asset balance.
Step 2: Calculate the adjustment amount
Since our existing right-of-use (ROU) asset and lease liability is $5,000, the remeasurement will record the difference between the new lease liability and the existing one, which would be $23,028 – $5,000 = $18,028.
The remeasurement journal entry will debit the Right-of-use (ROU) Asset balance for $18,028 and credit the Lease Liability account for the same amount. The date of recording the journal entry is October 1st, 2024, the same as the effective date of the signed lease extension.
After posting this remeasurement journal entry, the PML Noodle Shop now has the updated ROU asset and lease liability on the balance sheet that reflects the extended oven lease.
Please note that this is a simplified example to illustrate the remeasurement process. In the real world, further assessment is required beyond just the mathematical calculation, such as reviewing whether the lease classification is still the same.
- For lease extensions or renewals becoming effective after the original lease’s expiration (e.g., January 1st, 2025), no remeasurement is required. Simply record the lease treatment on that effective date as if it’s a new lease since, technically, it has no relationship with the preceding contract (the old one has expired). For accounting treatment of new leases, please refer to these two articles depending on the classification.
- If the lease extension is classified as a month-to-month or short-term lease, then there is an option to skip the recognition of ROU assets and liability. Please refer to this article for more details.
- A lease extension or renewal under ASC 842 is an agreement to prolong the lease beyond the original term, requiring a specific effective date for accurate accounting.
- If the extension/renewal becomes effective before the original lease ends, it triggers a remeasurement.
- Calculate the Present Value (PV) of Remaining Lease Payments: Use the current discount rate to find the PV of future lease payments. This recalculated PV becomes the updated lease liability and ROU asset.
- Book the Adjustment Based on the Difference: The difference between the new balance and the existing lease liability and ROU asset balance is the amount to be adjusted through a journal entry.
- Further analysis will also need to be performed, such as reviewing the lease classification and the contract consideration allocation.
- When a renewal/extension becomes effective after the original lease’s expiration, it’s treated as a new contract with its initial recognition on the renewal’s effective date.
- Month-to-month or Short-term extensions may qualify for simpler accounting treatments and be exempt from recognizing ROU assets and liabilities.