How to Account for Finance and Operating Leases

Lease post #3: The lessee's point of view

Most CPAs grapple with leases from the lessee’s point of view, so in this post we’ll take a look at leases from the lessee’s perspective. Under the new lease standard, what are the types of leases? Does the accounting vary based upon the type of lease? Are lease expenses different?

Change in Lease Accounting

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First, let’s start by defining the types of leases and how to classify them.

The Types of Leases

Upon the commencement date of the lease, the company should classify the lease as either a finance or an operating lease. (Under present lease standards a finance lease is referred to as a capital lease.)

Finance Lease

So what is a finance lease? A lease is considered a finance lease if it meets any of the following criteria:

  1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
  2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
  3. The lease term is for the major part of the remaining economic life of the underlying asset (today we use the 75% rule)
  4. The present value of the sum of the lease payments and residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset (today we use the 90% rule)
  5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term

While the bright-line criteria (e.g., lease term of 75% or more of economic life) have been removed, the basis for conclusions in the new lease standard acknowledges some of the old rules of thumb.  It says that one reasonable approach to determining whether the lease is for a major portion of the asset’s life is the 75% threshold. The conclusion goes on to say that “90 percent or greater is ‘substantially all’ the fair value of the underlying asset.” So, in effect, FASB removed the bright-lines as a rule but not in principle–the conclusion says FASB “does not mandate those bright lines.”

Operating Lease

And what is an operating lease? It’s any lease that is not a financing lease.

Accounting Similarities and Differences

Both operating and finance leases result in a right-of-use asset and a lease liability. The subsequent accounting for the two types of leases is quite different.

Finance Lease Accounting

The accounting for a finance lease is similar to capital lease accounting under present standards.

When a company enters into a finance lease, it will record the right-of-use asset and the lease liability. The amortization of the right-of-use asset will be straight-line and the amortization of the liability will be accounted for using the effective interest method. Consequently, lease expenses are front-loaded (i.e., expenses will decline throughout the lease term). The amortization expense and the interest expense will be presented separately on the income statement.

As we are about to see, operating lease accounting is significantly different, particularly with regard to accounting for the lease expense and the amortization of the right-of-use asset.

Operating Lease Accounting

The primary change in lease accounting lies in the operating lease area. Under ASC 842 a company will book a right-of-use asset and a lease liability for all operating leases greater than twelve months in length. (Under current lease standards, no asset or liability is recorded.) Will the operating lease expense be any different than it has been? No. But the recording and amortization of the right-of-use asset and the lease liability is new.

The Initial Operating Lease Entries

Let’s say a company has a five year operating lease for $1,000 per month and will pay $60,000 over the life of the lease. How do we account for this lease? First, the company records the right-of-use asset and the lease liability by discounting the present value of the payments using the effective interest method.  In this example, the present value might be $54,000. As the right-of-use asset and lease liability are amortized the company will (each month) debit rent expense for $1,000—the amount the company is paying. So the expense amount is still the same as it was under ASC 840.

Amortizing the Right-of-Use Asset and the Lease Liability

Well, how does the company amortize the right-of-use asset and the lease liability? The lease liability is amortized using the effective interest method, and the interest expense is a component of the rent expense. What’s the remainder of the $1,000? The amortization of the right-of-use asset. The $1,000 rent expense is made up of two components: (1) the interest expense for the month and (2) the right-of-use amortization amount which is a plug to make the entry balance. Even though the rent expense is made up of these two components, it appears on the income statement as one line: rent expense (unlike the finance lease which reflects interest expense and amortization expense separately).

Potential Impairments

Due to the mechanics of the straight-line lease expense calculation, the right-of-use asset amortization expense is back-loaded (i.e. the amortization expense component is less in the early part of the lease). One potential consequence of this slower amortization is the right-of-use asset may be subject to impairment, especially toward the end of the lease. The impairment rules do apply to the right-of-use asset.

Your Thoughts

So, what do you think of the new lease accounting? Is it better? Worse?

You can see my first two lease posts here:

Post 1: How to Understand the New Lease Accounting Standard

Post 2: Get Ready for Changes in Leases and the Leasing Industry

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