Lease Accounting Under ASC 842: Practical Examples for the CPA Exam
Work through detailed lease accounting examples under ASC 842. Covers lessee classification, right-of-use asset calculation, lease liability measurement, and journal entries for finance and operating leases.
ASC 842 Lessee Accounting Fundamentals
ASC 842 requires lessees to recognize a right-of-use (ROU) asset and a lease liability on the balance sheet for virtually all leases with terms greater than 12 months. The standard classifies leases as either finance leases or operating leases, and while both types appear on the balance sheet, they differ in their income statement and cash flow statement treatment. This topic is heavily tested on the CPA FAR exam, and candidates must be comfortable with both the classification criteria and the numerical calculations.
Lease Classification
A lease is classified as a finance lease if it meets any one of five criteria: (1) the lease transfers ownership to the lessee by the end of the lease term; (2) the lease contains a purchase option that the lessee is reasonably certain to exercise; (3) the lease term is for the major part of the remaining economic life of the asset (generally interpreted as 75% or more); (4) the present value of lease payments equals or exceeds substantially all of the fair value of the asset (generally interpreted as 90% or more); (5) the underlying asset is so specialized that it has no alternative use to the lessor at the end of the lease term. If none of these criteria are met, the lease is an operating lease.
Measuring the Lease Liability
The lease liability is measured at the present value of the lease payments not yet paid, discounted at the rate implicit in the lease if determinable, or the lessee's incremental borrowing rate. Lease payments include fixed payments, variable payments that depend on an index or rate, the exercise price of a purchase option (if reasonably certain), penalties for terminating the lease (if the lease term reflects termination), and residual value guarantees.
Example: Finance Lease
A company leases equipment with the following terms: annual lease payment of $50,000 payable at the end of each year, lease term of 5 years, the equipment has an economic life of 6 years (5/6 = 83%, exceeding 75%), the lessee's incremental borrowing rate is 6%, and there is no transfer of ownership or purchase option.
Present value of lease payments: $50,000 x PV annuity factor (6%, 5 years) = $50,000 x 4.2124 = $210,620.
At commencement:
- Debit: Right-of-Use Asset $210,620
- Credit: Lease Liability $210,620
Year 1 amortization schedule:
- Interest expense: $210,620 x 6% = $12,637
- Principal reduction: $50,000 - $12,637 = $37,363
- Ending lease liability: $210,620 - $37,363 = $173,257
- ROU asset depreciation: $210,620 / 5 years = $42,124
Year 1 journal entries:
- Debit: Interest Expense $12,637; Debit: Lease Liability $37,363; Credit: Cash $50,000
- Debit: Depreciation Expense $42,124; Credit: Accumulated Depreciation - ROU Asset $42,124
Total Year 1 expense (finance lease): $12,637 + $42,124 = $54,761. Notice how finance lease expense is front-loaded because interest expense is highest in the early years.
Example: Operating Lease
A company leases office space with the following terms: annual lease payment of $100,000 payable at the beginning of each year, lease term of 3 years, the building has an economic life of 30 years, and the incremental borrowing rate is 5%. None of the five finance lease criteria are met.
Present value of lease payments (annuity due since payments are at the beginning): $100,000 x PV annuity-due factor (5%, 3 years) = $100,000 x 2.8594 = $285,941.
At commencement (first payment is immediate):
- Debit: Right-of-Use Asset $285,941
- Credit: Lease Liability $285,941
- Debit: Lease Liability $100,000
- Credit: Cash $100,000
For an operating lease, total lease cost is straight-lined over the lease term: $300,000 total payments / 3 years = $100,000 per year. The single lease expense combines the interest component and the amortization component.
Year 1 calculations (after the initial payment):
- Lease liability after first payment: $285,941 - $100,000 = $185,941
- Interest on liability: $185,941 x 5% = $9,297
- Straight-line lease expense: $100,000
- ROU asset amortization (plug): $100,000 - $9,297 = $90,703
- Ending ROU asset: $285,941 - $90,703 = $195,238
Short-Term Lease Exception
Lessees may elect, by class of underlying asset, to not recognize ROU assets and lease liabilities for leases with a term of 12 months or less that do not contain a purchase option the lessee is reasonably certain to exercise. These leases are recognized on a straight-line basis over the lease term, similar to operating leases under the prior standard ASC 840.
Cash Flow Statement Classification
For finance leases, the principal portion of lease payments is classified as a financing activity, and the interest portion as an operating activity (or financing, consistent with the entity's policy for other interest). For operating leases, all lease payments are classified as operating activities. This difference can significantly affect reported operating cash flows.
Key Exam Tips
- Both finance and operating leases result in ROU assets and lease liabilities on the balance sheet.
- Finance leases produce front-loaded expense (interest + depreciation); operating leases produce straight-line lease expense.
- Always check whether payments are at the beginning (annuity due) or end (ordinary annuity) of the period.
- The interest rate used for discounting is the rate implicit in the lease or, if not determinable, the lessee's incremental borrowing rate.
- Remember the 75% of economic life and 90% of fair value bright-line thresholds for classification.
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