8.2 Leases, Income Taxes, and Impairment

Measurement Models That Drive FAR Entries

This section ties together three high-yield FAR skills: measuring lease assets and liabilities, measuring income tax expense, and recognizing impairment when carrying amounts are no longer recoverable. The 2026 Blueprint places lessee accounting and income taxes in Area III, Select Transactions. Impairment appears across Area II balance sheet accounts, including property, plant and equipment, investments, finite-lived intangibles, purchased software, and cloud computing arrangements.

Fair value measurement concepts also sit in Area III; the 2026 Blueprint revision summary says the fair value changes clarify scope rather than significantly change FAR content.

Lessee Accounting

Under ASC 842, a lessee generally records a right-of-use asset and a lease liability at commencement for leases longer than 12 months. The liability starts at the present value of lease payments, discounted at the rate implicit in the lease or, if not readily determinable, the lessee's incremental borrowing rate. The asset usually equals the liability, plus initial direct costs and prepaid lease payments, minus lease incentives received.

These mirror the old capital-lease tests but are now principles, not bright lines, though many candidates still apply the 75 percent of life and 90 percent of fair value benchmarks as practical screens. Finance leases recognize interest on the liability and straight-line amortization of the right-of-use asset separately, producing higher total expense early in the term (front-loading). Operating leases produce a single straight-line lease cost while still reducing the liability using the interest method. Variable payments based on usage or performance are expensed as incurred unless they are in-substance fixed payments.

A residual value guarantee is included in the liability only up to the amount the lessee expects to owe.

Income Taxes

Income tax expense is not just the tax return amount. It includes current tax expense, based on taxable income, plus or minus deferred tax expense or benefit, based on changes in temporary differences. Permanent differences (such as municipal bond interest or fines) never create deferred taxes; they only affect the effective rate.

A temporary difference exists when the book basis and tax basis of an asset or liability differ but will reverse in future periods. If book income exceeds taxable income because tax depreciation is faster, the entity records a deferred tax liability. If warranty expense is accrued for books before it is deductible for tax, the entity records a deferred tax asset. Measure deferred items at the enacted rate expected to apply when the difference reverses, not the current-year rate if a change is enacted.

A deferred tax asset needs a valuation allowance when it is more likely than not (greater than 50 percent) that some or all of the asset will not be realized. For uncertain tax positions, use two steps: first, the position must be more likely than not to be sustained on its technical merits; second, measure the benefit as the largest amount that is more than 50 percent likely to be realized on settlement.

Impairment And Fair Value

For held-and-used long-lived assets, test recoverability first. If the carrying amount exceeds undiscounted expected future cash flows, the asset fails the recoverability test, and impairment equals carrying amount minus fair value. Note the two different cash-flow concepts: undiscounted for the trigger, fair value for the loss. For assets held for sale, measure at the lower of carrying amount or fair value less cost to sell, and stop depreciating.

Finite-lived intangibles follow the long-lived asset recoverability model. Investments have separate impairment models depending on classification. Fair value questions may ask for valuation approaches (market, income, and cost) and hierarchy classification: Level 1 quoted prices in active markets, Level 2 observable inputs, Level 3 unobservable inputs.

A Worked Lease Entry

Suppose a lessee signs a three-year lease with payments of $30,000 at the end of each year and an incremental borrowing rate of 6 percent. The present value of an ordinary annuity factor for three years at 6 percent is about 2.673, so the lease liability and right-of-use asset both start near $80,190. In year one, interest is $80,190 x 6 percent = $4,811, and the $30,000 payment reduces the liability by $25,189. If this is a finance lease, the asset amortizes straight-line at $26,730 per year, so year-one total expense is $4,811 interest plus $26,730 amortization = $31,541, front-loaded.

If it is an operating lease, total lease cost is a level $30,000 per year, even though the liability still unwinds using the interest method behind the scenes.

A Worked Tax Reconciliation

A company reports $1,000,000 pretax book income, including $40,000 of tax-exempt municipal interest (a permanent difference) and $100,000 of excess tax depreciation (a temporary difference). At a 21 percent rate, taxable income is $1,000,000 - $40,000 - $100,000 = $860,000, so current tax expense is $180,600. The $100,000 temporary difference creates a deferred tax liability of $21,000. Total income tax expense is $180,600 + $21,000 = $201,600, and the effective rate falls below 21 percent because the municipal interest is never taxed.

Recognizing that the permanent difference moves the effective rate while the temporary difference shifts timing is exactly the distinction simulations test.

Exam Workflow

1. Identify the measurement model before calculating.
2. For leases, classify first, then build the liability (present value) and the asset.
3. For income taxes, separate permanent differences from temporary differences, then apply the enacted future rate.
4. For impairment, decide whether recoverability (undiscounted), fair value, or fair value less cost to sell is the required basis.
5. Tie every number to presentation: asset, liability, expense, gain or loss, and disclosure.