Lease Accounting Under ASC 842
ASC 842 replaced ASC 840 and requires lessees to recognize nearly all leases on the balance sheet. This is a heavily tested area on the FAR section of the CPA exam. Understanding classification criteria and journal entries is essential.
Lease Classification: Five Criteria (OWNES)
A lease is classified as a finance lease (lessee) or sales-type lease (lessor) if ANY one of these criteria is met:
| Criterion | Mnemonic | Test |
|---|---|---|
| Ownership transfer | O | Ownership of the asset transfers to the lessee by the end of the lease term |
| Written purchase option | W | Lessee has a purchase option that is reasonably certain to be exercised |
| Net present value | N | PV of lease payments ≥ substantially all (typically 90%+) of the asset's fair value |
| Economic life | E | Lease term is for the major part (typically 75%+) of the asset's remaining economic life |
| Specialized asset | S | Asset is so specialized that it has no alternative use to the lessor after the lease |
If NONE of these are met, the lease is an operating lease for the lessee and a direct financing or operating lease for the lessor.
Lessee Accounting: Finance Lease vs. Operating Lease
| Feature | Finance Lease | Operating Lease |
|---|---|---|
| Balance Sheet | ROU Asset + Lease Liability | ROU Asset + Lease Liability |
| Income Statement | Amortization expense + Interest expense (front-loaded) | Single lease expense (straight-line) |
| Cash Flow Statement | Principal: Financing; Interest: Operating | All payments: Operating |
| ROU Asset Amortization | Typically straight-line over shorter of lease term or useful life | Calculated as plug: Total lease expense minus interest expense |
| Expense Pattern | Higher total expense in early years (front-loaded) | Equal total expense each period (straight-line) |
Initial Recognition (Both Lease Types)
| Item | Measurement |
|---|---|
| Lease Liability | PV of lease payments, discounted at the rate implicit in the lease (or lessee's incremental borrowing rate if implicit rate is not readily determinable) |
| ROU Asset | Lease Liability + Initial direct costs + Prepaid lease payments − Lease incentives received |
Lease Payments Included in Measurement
- Fixed payments (less any lease incentives receivable)
- Variable payments based on an index or rate (using rate at commencement)
- Amounts probable of being owed under residual value guarantees
- Exercise price of purchase option (if reasonably certain to exercise)
- Penalties for terminating the lease (if lease term reflects termination)
Lessor Classification and Accounting
| Lease Type | When | Lessor Treatment |
|---|---|---|
| Sales-Type | Any OWNES criterion met | Derecognize asset; recognize net investment in lease; recognize selling profit/loss at commencement; interest income over term |
| Direct Financing | No OWNES criterion met BUT PV of payments + guaranteed RV = substantially all of FV | Derecognize asset; recognize net investment; defer selling profit (added to net investment); interest income over term |
| Operating | Neither sales-type nor direct financing | Keep asset on books; depreciate normally; recognize rental income straight-line |
Short-Term Lease Exemption
Leases with a term of 12 months or less (with no purchase option reasonably certain to be exercised) can be exempted from balance sheet recognition. Expense is recognized straight-line over the lease term. This is an accounting policy election made by asset class.
Key Journal Entries: Lessee at Commencement
- Both types: Dr. Right-of-Use Asset / Cr. Lease Liability (at PV of payments)
- Finance lease periodic: Dr. Amortization Expense / Cr. Accumulated Amortization; Dr. Interest Expense / Cr. Lease Liability
- Operating lease periodic: Dr. Lease Expense (straight-line amount) / Cr. Lease Liability (principal portion) / Cr. ROU Asset (plug)
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