Lease Accounting Under ASC 842: What CPA Candidates Must Know

Overview of ASC 842: Leases

ASC 842 fundamentally changed lease accounting by requiring lessees to recognize virtually all leases on the balance sheet. Under the previous standard (ASC 840), operating leases were off-balance-sheet arrangements. Now, both finance leases and operating leases result in a right-of-use (ROU) asset and a lease liability on the lessee's balance sheet. This topic is heavily tested on the CPA FAR exam.

Lease Classification for Lessees

A lessee classifies a lease as a finance lease if any one of five criteria is met. These criteria closely mirror the old capital lease tests under ASC 840:

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 (the 75% threshold from ASC 840 is not codified, but it remains a common benchmark).
4. The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset (the 90% threshold is still widely used in practice).
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.

If none of these criteria are met, the lease is classified as an operating lease.

Lessee Accounting: Finance Leases

At commencement, the lessee records a right-of-use asset and a lease liability at the present value of future lease payments. The discount rate used is the rate implicit in the lease if readily determinable; otherwise, the lessee uses its incremental borrowing rate.

After commencement, the lessee amortizes the ROU asset on a straight-line basis (or another systematic basis) and recognizes interest expense on the lease liability using the effective interest method. This front-loads expense recognition because interest expense is higher in early periods. The income statement presentation separates amortization expense (typically in operating expenses) from interest expense (in non-operating).

Initial Measurement

The lease liability includes fixed payments, variable payments that depend on an index or rate, amounts expected to be owed under residual value guarantees, the exercise price of a purchase option if the lessee is reasonably certain to exercise it, and payments for penalties for terminating the lease if the lease term reflects the lessee exercising a termination option. Variable payments that are not based on an index or rate are expensed as incurred.

The ROU asset equals the lease liability plus any initial direct costs incurred by the lessee, plus any lease payments made at or before commencement, minus any lease incentives received.

Lessee Accounting: Operating Leases

At commencement, the lessee also records an ROU asset and a lease liability at the present value of future lease payments. The key difference is in subsequent measurement: operating leases recognize a single lease expense on a straight-line basis over the lease term. The lease liability is still reduced using the effective interest method, but the ROU asset is adjusted as a plug to achieve straight-line total expense.

Exam tip: The total expense under an operating lease is the same each period. This means the ROU asset does not amortize on a straight-line basis; instead, it is reduced by the difference between the straight-line expense and the interest on the liability each period.

Lessor Accounting

ASC 842 largely preserved the lessor accounting model from ASC 840. Lessors classify leases as sales-type, direct financing, or operating:

• Sales-type lease: Meets any of the five classification criteria. The lessor derecognizes the underlying asset, recognizes a net investment in the lease, and may recognize selling profit or loss at commencement.
• Direct financing lease: Meets any of the five criteria AND the lessor has a residual value guarantee from a third party, making collection plus residual substantially certain. Any selling profit is deferred and recognized over the lease term as part of interest income. A selling loss is recognized immediately.
• Operating lease: Does not meet any of the five criteria. The lessor keeps the asset on its books, continues to depreciate it, and recognizes lease income on a straight-line basis.

Short-Term Lease Exemption

ASC 842 provides a practical expedient for short-term leases. A lease that, at commencement, has a maximum possible term of 12 months or less (including any renewal options the lessee is reasonably certain to exercise) may be excluded from balance sheet recognition. The lessee instead recognizes lease payments as expense on a straight-line basis over the lease term. This election is made by class of underlying asset.

Lease Modifications and Reassessments

A lease modification that grants an additional right of use not included in the original lease is treated as a separate lease if the additional right of use is priced commensurate with its standalone price. Otherwise, the lessee remeasures the lease liability and adjusts the ROU asset based on the revised terms, using a revised discount rate.

Key Journal Entries for the CPA Exam

At Lease Commencement (Both Lease Types)

Debit ROU Asset, Credit Lease Liability. The amount equals the present value of lease payments.

Subsequent Periods: Finance Lease

Debit Interest Expense, Credit Lease Liability (for the interest portion). Debit Amortization Expense, Credit ROU Asset (for the amortization). Debit Lease Liability, Credit Cash (for the payment).

Subsequent Periods: Operating Lease

Debit Lease Expense (single line, straight-line amount), Credit Lease Liability (for the difference between the cash payment and interest on the liability), Credit ROU Asset (as a plug to balance), Credit Cash (for the payment).

Exam Preparation Tips

• Be comfortable computing the present value of lease payments using a present value of an annuity table or formula.
• Understand the difference between front-loaded expense (finance lease) and straight-line expense (operating lease).
• Know the five classification criteria and how to apply them for both lessees and lessors.
• Practice building amortization schedules for both finance and operating leases.
• Remember that the short-term lease exemption applies only when the maximum possible term is 12 months or less.