Key Takeaways
- ASC 842 requires lessees to recognize nearly all leases on the balance sheet as right-of-use assets and lease liabilities
- Lessees classify leases as either finance leases or operating leases based on five criteria; lessors use the same criteria plus additional tests
- Finance leases result in front-loaded expense (interest plus amortization); operating leases result in straight-line expense
- The lease liability is measured at the present value of lease payments using the rate implicit in the lease or the lessee's incremental borrowing rate
- Short-term leases (12 months or less) may be exempted from balance sheet recognition under a practical expedient
Lease Accounting Under ASC 842
ASC 842, Leases, became effective for public companies in 2019 and fundamentally changed lease accounting by requiring lessees to recognize nearly all leases on the balance sheet. This standard is heavily tested on the CMA exam.
Definition of a Lease
A contract is, or contains, a lease if it conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.
Control exists when the customer has:
- The right to obtain substantially all the economic benefits from use of the asset, AND
- The right to direct the use of the asset throughout the period of use
Lease Classification - Lessee
Lessees classify each lease as either a finance lease or an operating lease at the commencement date. A lease is a finance lease if it meets ANY of the following five criteria:
| Criterion | Description | Memory Aid |
|---|---|---|
| 1. Ownership transfer | Ownership transfers to lessee by end of lease term | "O" |
| 2. Purchase option | Lessee has option to purchase that is reasonably certain to be exercised | "W" |
| 3. Lease term | Lease term is for major part of remaining economic life (typically 75%+) | "N" |
| 4. Present value | Present value of lease payments equals or exceeds substantially all (typically 90%+) of fair value | "E" |
| 5. Specialized asset | Asset is of such specialized nature that it is expected to have no alternative use to lessor at end of term | "S" |
Exam Tip: Remember "OWNS" for finance lease criteria: Ownership transfers, Written purchase option, 75% of life (Not explicit but implied), 90% of fair value (Substantially all), Specialized asset.
If none of the criteria are met, the lease is an operating lease.
Initial Measurement - Lessee
At the commencement date, the lessee recognizes:
1. Right-of-Use (ROU) Asset:
- Initial lease liability amount
- Plus: Lease payments made at or before commencement (less any lease incentives received)
- Plus: Initial direct costs incurred by lessee
- Plus: Estimate of costs to dismantle/remove asset or restore site
2. Lease Liability:
- Present value of lease payments not yet paid
Lease Payments Include:
- Fixed payments (less any lease incentives receivable)
- Variable payments based on an index or rate (using the index at commencement)
- Exercise price of a purchase option if reasonably certain to be exercised
- Payments for penalties for terminating the lease if lease term reflects termination
- Fees paid by lessee to owners of a special-purpose entity for structuring the transaction
- For finance leases only: amounts probable of being owed under residual value guarantees
Discount Rate
The discount rate used to calculate the present value of lease payments:
| Preference | Rate |
|---|---|
| First choice | Rate implicit in the lease (if readily determinable) |
| Second choice | Lessee's incremental borrowing rate |
The incremental borrowing rate is the rate the lessee would pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments.
Subsequent Measurement - Lessee
Finance Lease
| Component | Treatment |
|---|---|
| ROU Asset | Amortized on straight-line basis (typically) over shorter of lease term or useful life |
| Lease Liability | Effective interest method - interest expense calculated on carrying amount |
| Total Expense | Interest expense + Amortization expense (front-loaded pattern) |
Journal Entries:
Recognition of Interest:
Dr. Interest Expense
Cr. Lease Liability
Payment:
Dr. Lease Liability
Cr. Cash
Amortization:
Dr. Amortization Expense
Cr. ROU Asset (Accumulated Amortization)
Operating Lease
| Component | Treatment |
|---|---|
| ROU Asset | Adjusted each period to achieve straight-line lease expense |
| Lease Liability | Effective interest method |
| Total Expense | Single lease expense on straight-line basis |
The ROU asset becomes a "plug" figure - it is reduced each period by the difference between straight-line lease expense and interest expense on the liability.
Example - Operating Lease:
A company enters into a 3-year operating lease with annual payments of $10,000 at the end of each year. The discount rate is 6%.
Initial Lease Liability = $10,000 x 2.6730 (PV factor) = $26,730
| Year | Beginning Liability | Interest (6%) | Payment | Ending Liability |
|---|---|---|---|---|
| 1 | $26,730 | $1,604 | $10,000 | $18,334 |
| 2 | $18,334 | $1,100 | $10,000 | $9,434 |
| 3 | $9,434 | $566 | $10,000 | $0 |
Annual straight-line lease expense = $30,000 / 3 years = $10,000
| Year | Interest | ROU Reduction | Total Expense |
|---|---|---|---|
| 1 | $1,604 | $8,396 | $10,000 |
| 2 | $1,100 | $8,900 | $10,000 |
| 3 | $566 | $9,434 | $10,000 |
Lease Classification - Lessor
Lessors classify leases as:
- Sales-type lease - If ANY of the five criteria (OWNS) are met
- Direct financing lease - If none of the five criteria are met, BUT the present value of lease payments plus any residual value guaranteed by third party equals or exceeds substantially all of the fair value, AND collection is probable
- Operating lease - All other leases
Lessor Accounting Summary:
| Lease Type | Balance Sheet | Income Recognition |
|---|---|---|
| Sales-type | Derecognize asset; recognize lease receivable and possibly selling profit | Profit at commencement; interest income over lease term |
| Direct financing | Derecognize asset; recognize lease receivable; defer initial direct costs | Interest income over lease term (no selling profit at commencement) |
| Operating | Keep asset on books | Lease income on straight-line basis; depreciate asset |
Short-Term Lease Exemption
A lessee may elect, as an accounting policy by class of underlying asset, not to recognize ROU assets and lease liabilities for short-term leases.
Short-term lease definition:
- Lease term of 12 months or less at commencement
- Does not include a purchase option that the lessee is reasonably certain to exercise
If elected, lease payments are recognized as expense on a straight-line basis over the lease term.
Lease Modifications
A lease modification is a change to the terms of a lease that was not part of the original lease. Accounting depends on whether the modification:
-
Grants additional right of use not in original lease AND price increase is commensurate with standalone price:
- Account for as a separate, new lease
-
All other modifications:
- Remeasure the lease liability using a revised discount rate
- Adjust the ROU asset
- May require reclassification between finance and operating
Sale and Leaseback Transactions
If the transfer of the asset qualifies as a sale under ASC 606:
- Seller-lessee derecognizes the asset and recognizes any gain or loss (adjusted for off-market terms)
- Buyer-lessor recognizes the asset and applies lessor accounting to the leaseback
If the transfer does not qualify as a sale:
- Seller-lessee keeps the asset on its books
- Both parties account for the transaction as a financing arrangement
Under ASC 842, which of the following would result in classification of a lease as a finance lease for the lessee?
A company enters into a 5-year operating lease with annual payments of $20,000 due at the end of each year. The present value of the lease payments is $84,000. What is the total lease expense recognized in the first year?
Which discount rate should a lessee use to measure the lease liability if the rate implicit in the lease cannot be readily determined?
A company has a finance lease with a right-of-use asset of $100,000 and a lease liability of $100,000 at commencement. In Year 1, interest expense is $8,000, the lease payment is $25,000, and the ROU asset is amortized by $20,000. What is the total expense recognized in Year 1?