Last Updated on June 15, 2023 by Morgan Beard
Navigating the complexities of lease accounting under ASC 842 can seem overwhelming. However, with a clear understanding of the basic principles and some practical examples, you can confidently account for finance leases and ensure accurate financial reporting for your organization. In this blog post, we will break down the key concepts of finance lease accounting and provide approachable explanations and examples to help you master this topic.
Definition and Characteristics of Finance Leases
Finance leases are a type of lease arrangement where the lessee obtains the right to use an asset for the major part of its economic life. This results in a requirement to recognize the leased asset as well as the corresponding lease liability on the balance sheet, reflecting the lessee’s control and obligation to pay for the leased asset.
To determine if a lease qualifies as a finance lease under ASC 842, there are specific criteria that must be met. These criteria include the transfer of ownership at the end of the lease term, the option to purchase the leased asset at a bargain price, the lease term covering a significant portion of the asset’s economic life, and the present value of lease payments exceeding substantially all of the asset’s fair value.
Recognition and Measurement of Finance Leases
Once a lease is identified as a finance lease, it must be recognized and measured correctly in the lessee’s financial statements. The lessee shall record the right-of-use (ROU) asset and the lease liability on the balance sheet at the present value of the lease payments. The lease liability represents the present value of the remaining lease payments, including interest, which is calculated using the effective interest rate method.
The ROU asset is initially recorded at the same amount as the lease liability, unless reconciling items such as deferred rent, prepaid rent or lease incentives exist and is subsequently amortized over the lease term. The amortization is typically recognized on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the ROU asset’s future economic benefits.
Presentation and Disclosure Requirements for Finance Leases
Presentation and disclosure requirements are an important aspect of finance lease accounting under ASC 842. The financial statements should provide clear and transparent information about the nature, amount, timing, and uncertainty of the lessee’s cash flows pertaining to finance leases.
ASC 842 requires qualitative and quantitative disclosures related to finance leases, including information about the nature of the leases, the significant assumptions used in measuring lease liabilities, maturity analysis of lease liabilities, and other relevant lease-related information. These disclosures help users of the financial statements better understand the impact of finance leases on the organization’s financial position, performance, and cash flows. To learn more about the disclosure requirements please visit our blog post.
Comparison with Capital Lease Accounting
Under the previous lease accounting standard (ASC 840), leases were classified as either capital leases or operating leases. Capital leases were recognized on the balance sheet, similar to finance leases under ASC 842, while operating leases were not recorded on the balance sheet at all. ASC 842 eliminated that distinction between capital leases and operating leases for lessees and requires all leases, including operating leases, to be recognized on the balance sheet as ROU assets and lease liabilities.
This change in lease accounting treatment has significant implications for organizations’ financial statements, as it affects their balance sheet, income statement, and cash flow statement. Understanding the differences between the previous capital lease accounting and the current finance lease accounting under ASC 842 is crucial for accurate financial reporting and compliance with the updated standard.
Examples of Journal Entries for Finance Leases
To illustrate the practical application of finance lease accounting, let’s look at some examples of journal entries that may be required.
You work at XYZ Company that has leased a forklift over a 3 year term. The monthly payments are $5,000 to be paid at the beginning of each month. You have determined that XYZ’s incremental borrowing rate is 5%. It was determined that this forklift was a finance lease.
Using a present value calculator you have determined that your initial lease liability balance is $167,523.63. Given that there were no prepayments, no initial direct costs and no deferred rent for this lease the right-of-use asset will also equal $167,523.63 at inception of the lease.
To record the initial recognition of this forklift lease XYZ Company would post the following journal entries.
- Initial Recognition of a Finance Lease:
DR: Right-of-use Asset $167,523.63
CR: Lease Liability $167,523.63
Now that the initial lease liability and right-of-use asset have been recorded XYZ Company must now reduce these balances every month through a series of journal entries as outlined below.
XYZ Company must first record the $5,000 lease payment which will reduce the lease liability
- Payment of Lease Liability:
DR: Lease Liability $5,000
CR: Cash $5,000
Next, XYZ Company will need to record the monthly amortization on the right-of-use asset balance. This is done by taking the initial right-of-use asset of $167,523.63 and dividing it by the number of periods in the lease (36 months).
$167,523.63/36 = $4,653.43
- Amortization of Right-of-use Asset:
DR: Amortization Expense $4,653.43
CR: Accumulated Amortization – Right-of-use Asset $4,653.43
The last monthly journal entry to record is the monthly interest impact on the lease liability. Similar to a mortgage payment, every payment against the lease liability does not all go towards the principle. Interest expense is also recognized.
To calculate the monthly interest expense for the month XYZ Company multiplied the beginning balance (for the month) of the lease liability of $167,532.63 LESS the payment for the month of $5,000 by the monthly incremental borrowing rate of 0.42% (5% divided by 12 months) to arrive at an interest expense of $677.18.
- Interest Expense on Lease Liability:
DR: Interest Expense $677.18
CR: Lease Liability $677.18
This process is repeated during every month-end close until the lease term expires at the end of year 3.
It’s important to note that the specific journal entries may vary depending on the individual lease arrangement and the organization’s accounting policies. It’s crucial to consult with accounting professionals and follow the specific guidance provided by ASC 842 to ensure accurate and compliant finance lease accounting.
Finance lease accounting under ASC 842 can be complex, but with a solid understanding of the definition and characteristics of finance leases, recognition and measurement requirements, presentation and disclosure requirements, comparison with capital lease accounting, and practical examples of journal entries, you can confidently navigate the landscape of lease accounting and ensure accurate financial reporting for your organization. Remember to seek professional advice and stay up-to-date with the latest accounting standards to ensure compliance with ASC 842 and other applicable regulations. By mastering finance lease accounting, you can effectively manage lease agreements and make informed financial decisions for your organization’s success.