Accounting for a Finance Lease Under ASC 842
Last Updated on February 9, 2023 by Morgan Beard
What does ASC 842 mean in practice if your real estate portfolio consists of finance leases? Well, the first change is in the wording: a capital lease under ASC 840 is now called a finance lease under ASC 842. Along with this name change, there is also additional accounting compliance scope with the new standard, set in motion by the Financial Accounting Standards Board.
In this piece, we’ll define and illustrate some ASC 842 finance lease best practices.
What are Finance Leases Under ASC 842?
A lease classification test is the first step to determining whether you have a finance or an operating lease. At its core, a finance lease transfers ownership of the leased asset to the lessee at the end of the lease term.
There are five main lease classification criteria, which we’ve detailed in our blog on How to Perform a Lease Classification Test. For our purposes today, the critical difference between accounting for operating leases and accounting for finance leases is that the latter requires both a lease amortization schedule as well as a recorded interest expense.
Once you have determined if you have a finance lease not operating lease, then you are ready to start calculating your ROU assets and lease liability. If you do have an operating lease, then take a look at our sister post, How to account for operating leases under ASC 842.
How to Account for a Finance Lease Under ASC 842
After obtaining the straight-line expense, you need to move on to the heart of ASC 842 finance lease accounting. ASC 842 replaces the old obligation under ASC 840 to record capital lease assets and lease obligations. In its place, teams need to record:
- A lease liability, which is the total financial obligation owed by the lessee toward the lessor.
- A right-of-use asset, which is a valuation of the period of a lessee’s access to an asset.
- Interest expense is the interest accrued on the amount owed to a lessor
To record these figures under ASC 842 for a finance lease, teams should follow these steps:
- In the statement of financial position: Record the right-of-use asset and the lease liability, which are initially measured at the present value of the lease payments.
- In the statement of comprehensive income: Record the interest on the lease liability separately from the amortization of the right-of-use asset.
- In the statement of cash flows: Under financing activities, list repayments of the principal portion of the lease liability. Within operating activities, list interest payments on the lease liability and variable lease payments.
The next step in ASC 842 finance lease accounting is measuring the straight-line expense. This is included in the income statement and helps show a lease’s direct impact on cash flow in each period. You can calculate the straight-line expense with the following equation:
In this equation, the total of all lease payments throughout the lease period, in addition to any initial direct costs incurred by the lessee, gets subtracted by any lease incentives offered by the lessor, all divided by the number of periods in the lease term.
Accounting for Finance Lease Modifications Under ASC 842
Many new nuances have been introduced to finance lease accounting under ASC 842. Under the new standard, some modifications to a lease will result in a new lease that must be recorded. But in all other cases, changes will trigger a re-measurement of the lease liability and right-of-use asset.
When it comes to recalculating the right-of-use asset and lease liability, some key modifications that can trigger reassessment are changes in the discount rate for future payments, a change in the lease term, or some new incentives or up-front costs placed on the lessee by the lessor.
Identifying Embedded Leases
Under the new lease accounting standards, many companies will need to evaluate if their contracts have an embedded lease. Three prerequisites must be met in order for a contract to contain an embedded lease:
- the contract depends on an identified asset
- the customer has the right to obtain substantially all of the economic life benefits from use of the PP&E
- the customer has the right to direct the use of the PP&E
The subsequent accounting treatment for embedded leases entails separation of non-lease and lease components. IT contracts are the most common embedded lease examples, combining services like support and the right to use an underlying asset like servers.
So in this next section we will look at a practical example that applies lessee accounting principles to the underlying asset within an embedded lease of an IT contract.
Finance Lease Accounting – Example of Embedded Lease
John is the CTO of an international data company. He and his IT team has signed a contract that includes a fleet of servers and support of those servers with the following terms:
- Lease commencement date: August 1, 2022
- Lease Classification: Finance lease
- Lease term: 5 years
- Fair market value of the server fleet: $500,000
- Payments Frequency: Monthly
- Lease Payments: $10,000
- Service Payments: $1,000
- Incremental Borrowing Rate: 7%
- Useful life of the server fleet: 10 years
- At the end of the lease term, John has the purchase option of the fleets for $200,000, which is the asset’s fair market value at the end of the lease term.
Finance Lease Accounting – Example with a Modification
A lease modification outlines a change in scope within a lease agreement and is a common occurrence between terminations, extension options, change in lease term, change in rent etc. Accounting for a lease modification can receive one of two accounting treatments:
- It is treated as a separate lease
- It is not treated as a separate lease
In this scenario, our lease modification will not be treated as a separate lease. Many entities will encounter a modification that includes a change due to variable payments like CPI also known as consumer price index or exercise their right to renew, terminate, expand etc.
ACME Inc. entered into a lease agreement on November 1, 2022 to lease a new company van for a term of 23 months. The fixed cost per month was $490. And, the lease has an extension option for a two-year period at the same price. ACME Inc believes they will only need the vehicle for 23 months at this point in time so they do not currently plan to exercise their right to renew option.
Upon assessment by ACME Inc’s finance team, it was determined that this lease is a finance lease. Initial calculations revealed that this lease will bring a ROU Asset of $11,015.98 and a corresponding lease liability of the same amount.
Two days later on November 3, 2022, ACME Inc., signed a large contract with a new customer. Due to the large new contract ACME Inc. knows that they will now need the leased van for the additional two-year period.
Given the updated business use case, ACME Inc. now knows they will need the leased vehicle for the additional two-year period. So, they will have to re-assess the lease accounting with respect to the van lease.
This has triggered what is called a re-measurement due to the fact that the assumptions and judgements made with respect to this lease have changed since the initial accounting was performed.
Modification to the Terms:
On November 3, 2022, ACME Inc. exercised their right to renew their their van lease which resulted in a re-measurement. Upon re-measuring the lease, ACME Inc. noted that an adjustment of $11,048.22 was required to capture the new assumptions and circumstances surrounding the leased van.
Accounting for finance leases under ASC 842 will become routine for nonprofit, private, and public companies. Creating your journal entries will require lease liability, ROU assets, and interest calculations.
Transitioning to ASC 842 finance lease accounting will be a significant challenge for your business and impact your company’s balance sheets. As outlined in the examples, lessee accounting calculations will provide your team better insight into your leasing agreement and financial reporting.
Take a look at our comprehensive lease accounting resource hub to find out about key definitions and calculations under ASC 842 and finance leases. If you have any questions, reach out to our team. Schedule a demo today if you’re ready to test drive our lease accounting software.
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