Back to FASB , Back to ASC 842
By LeaseCrunch® on
First things first: Let’s set some definitions straight, because straight-line expense is different from straight-line amortization and straight-line depreciation. “Amortization” is a term used to refer to the decrease in value that an intangible asset, such as a lease, experiences over a set period of time. Whereas straight-line amortization is a term used to describe the decrease in value of intangible assets, depreciation is used to refer to the decrease in value of tangible assets, such as a car, an office, or a piece of construction equipment. In summary: leases are amortized, and underlying assets are depreciated, as depreciation is the decline in an asset’s value over the course of a lease. Amortization and depreciation are not new concepts that came about with the new lease standards; the depreciation of assets and amortization of capital leases (now finance leases) are something that lessees and lessors have done for decades. To account for rent payments and measure rent expenses, there are a few things to keep in mind, including the recognition of a straight-line rent expense. The straight-line method of expense is a way to recognize lessee lease payments on the income statement. With the straight-line method, all lease payments are distributed evenly across the term of the lease, regardless of when the lessee actually makes their lease payments. The straight-line expense method has always been required for operating leases because a lessee controls the underlying asset consistently throughout the term of the lease, so the related expense must be recognized on a consistent basis as well. Lease payments could be on a typical schedule, like month-to-month, or a lessee could pay everything up-front, or there could be a buy-out option at the end of the lease. The straight-line method cuts through all the noise of the varying times at which a lessee pays their rent and shows the payments distributed evenly over the course of the lease. Let’s consider an example with a buy-out situation. Say you have $1,000 monthly payments over a two-year lease term that total $24,000. If there’s a buy-out for $12,000, the total of the monthly payments plus buy-out is $36,000. To recognize that total expense evenly over the lease term, divide the total by the duration of the lease in months (24 months). The straight-line expense is $3,000 each month.What is the Straight-Line Method of Expense for Lease Accounting?
Straight-Line Rent Expense Under ASC 842
Under ASC 842, entities must record assets and liabilities for operating leases for the first time (capital leases, now called finance leases, were previously recorded on the balance sheet). The lease liability of these assets is the present value of future lease payments. The right-of-use asset is the lease liability plus initial direct costs and lease payments made at or before lease commencement, less incentives received.
Regardless of how and when lease payments are made for these operating leases, the lease expense—which is the same as the straight-line rent expense recognized under ASC 840 for operating leases—should be recorded on the income statement.
How Do You Calculate Expense Using the Straight-Line Method?
Calculating the straight-line expense of an asset is incredibly straightforward. You just take the total amount of lease payments and divide it by the number of months of the lease term. This process is the same for both ASC 840 and 842.
Straight-Line Rent Expense Measurement Considerations
These factors may also need to be factored into your straight-line rent expense measurement:
Lease incentives
Sometimes a lessor offers a lease incentive to a lessee for funding lessee improvements to the underlying asset or to entice the lessee to sign a lease in a more difficult leasing environment. If the lease incentive is not paid by the lease commencement date, that lease incentive reduces the lessee’s lease payments at the expected receipt date, reducing the lease liability along with the ROU asset.
Rent-free periods
There’s a change in mindset on the accounting treatment for periods when a lessee is not required to pay rent within a lease. Under the previous lease standard, ASC 840, this often resulted in deferred rent balances on the balance sheet. With ASC 842, there is no deferred rent balance to maintain because this amount is accounted for in the lease liability and ROU asset.
Rent escalations
When base rent payments increase in a lease, the known changes should be factored into the Lease Liability and ROU Asset as well as straight-line rent expense calculations.
What is a Straight-Line Expense Example?
Here’s an example of the straight-line method of expense:
Suppose a lessee had control of an underlying asset as of January 1, 2023, which means that’s also when the lease term commenced. According to the contract agreed upon by the lessor and lessee, the lessee doesn’t have a lease payment for the first six months of their lease, so the first lease payment is July 1, 2023.
Starting July 2023, the monthly lease payments are $1,000 for the remainder of the two-year lease, totaling $18,000. Divide that $18,000 by the full lease term of 24 months and the straight-line expense is $750/month.
Why is Straight-Line Expense Important?
The straight-line expense method serves multiple purposes in lease accounting:
- It ensures expenses are matched to the specific time period the asset is used, regardless of payment intervals. It also properly accounts for the lessee's right to use the asset throughout the entire lease term. Thus, organizations recognize expenses consistently over the appropriate duration of asset usage.
- It attempts to eliminate hijinx with lease payments, where an organization could time payments in a manner that would materially increase or decrease expenses to manipulate their financial statements.
- Importantly, it makes the accounting for leases more transparent for the financial statement users.
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Frequently Asked Questions
Does GAAP Require Straight-Line Rent?
Yes, under GAAP (Generally Accepted Accounting Principles), lessees are required to recognize operating lease expenses on a straight-line basis over the lease term. However, this may not be true if there is another systematic method more representative of the time pattern in which the use benefit from the leased asset is diminished.
Do You Have to Use the Straight-Line Rent Method?
Under ASC 842 and IFRS 16 lease accounting standards, lessees are required to recognize a straight-line rent expense for operating leases to ensure consistent expense recognition over the lease term.
What Is the Straight-Line Deferred Rent?
Under ASC 842, deferred rent is no longer calculated and included on the balance sheet. Under the previous lease accounting standard, deferred rent was the difference between what the lessee actually pays and the recorded straight-line expense. Under the new lease accounting standard, you simply record the lease liability, which is the present value of future lease payments, and a corresponding right-of-use (ROU) asset, which is the lease liability plus prepaid rent and initial direct costs, less incentives received.
What Is the Straight-Line Expense for ASC 842?
The straight-line expense for ASC 842 refers to the even allocation of lease costs over the lease term, ensuring consistent lease expense recognition, regardless of variations in actual lease payments. To calculate the straight-line expense, divide the total amount of lease payments by the number of periods in a lease.
What Is an Example of Straight-Line Depreciation?
An example of straight-line depreciation could be buying a new company car. If the car is $25,000 and the salvage value is $5,000, you will subtract those to get $20,000. Then, divide that difference by the asset’s useful life. In this case, it’s 5 years. In this example, the annual straight-line depreciation of the company car is $4,000.
What Is the Straight-Line Amortization of Intangibles?
The straight-line amortization of intangibles is how you decrease the value of an intangible asset at a constant rate over time. To calculate the straight-line amortization of intangibles, divide the book value of the asset by the life of the intangible asset.
How Many Years Does a Straight-Line Expense Last?
The length of straight-line expense is wholly dependent on the length of a lease or the useful life of an asset.
