By LeaseCrunch® on December 6, 2022 at 12:36 PM
ASC 842, which replaces the previous GAAP standard ASC 840, changes the way leases are classified and recognized, which therefore affects how lease accounting is executed. Before the alteration, leases were either capital or operating leases; with the new standard, capital leases are now called finance leases. However, the accounting calculations for capital-now-finance leases have remained the same. Operating leases, in contrast, are still the same by name but are recognized in a different way.
But that’s only the beginning. Let’s start with some basic definitions and then jump into the nitty gritty, answering questions like “what qualifies as a finance lease?” and “do operating leases go on the balance sheet?”.
As stated above, finance and capital leases are nearly the same in everything but name. Leases are classified as ‘finance’ when they have characteristics that make them similar to a purchase of the underlying asset. There are five criteria to consider, any one of which will result in a lease being classified as ‘finance.’ For example, if the total lease payments are substantially all of the leased asset’s fair value, or the lease term is a major part of the leased asset’s economic life, that will be a finance lease. Finance leases then have imputed interest and are amortized over the life of the lease.
Operating leases are lease contracts where the terms do not mimic a purchase of the underlying asset. For example, there is no ownership transfer at the end of the lease and the leased asset could be used by someone else after the lease has ended. In other words, when none of the five criterion used to classify a lease are true, then you have an operating lease.
Operating leases are used for the limited-term leasing of assets and include traditional renting relationships. Before the new lease accounting standards, these types of leases were solely expensed and the leased asset and the liabilities associated with it were not included on the balance sheet. Now, regardless of whether a lease is operating or finance, an asset and liability must be recorded on the financial statements.
What is a Finance Lease Example?
The previous lease standard considered four “bright-line” rules when classifying a lease as capital vs. operating. These rules were clear, but inflexible and could result in calculations that did not make sense for a particular organization. Under the new lease standard, these criteria have been updated to allow organizations more flexibility and judgment when classifying a lease.
To be classified as a finance lease, at least one of the following criteria must be true:
- A transferral of ownership of an asset to the lessee at the end of the term of the initial lease.
- The lessee is reasonably certain that they will exercise a purchase option at the end of the term of the lease.
- The leased asset has no alternative use to the lessor at the end of the lease.
- The lease term is a major part of the economic life of the underlying asset (75% was the previous common bright line test number, and most organizations continue to use this to determine “major part”).
- The present value of lease payments is substantially all of the fair value of the leased asset (90% was the previous bright line test number, and most organizations continue to use this to determine “substantially all”).
What is an Operating Lease Example?
It’s quite simple: follow the above list of criteria. Whatever lease does not classify as a finance lease is an operating lease.
Which is Better: Finance or Operating Lease?
Leases allow organizations to “pay as they go” for the use of a needed asset without the burden of ownership and oftentimes with limited maintenance responsibilities. That is a quintessential aspect and advantage of a lease agreement; a lessee gets the benefits of an asset without actually having to own that asset, and a lessor gets to turn a profit on their asset.
However, it was not always the case that all types of leases were recorded on the lease balance sheet. Many companies used to prefer to classify their leases as operating leases precisely because they were only recorded on their income statement— they used to have no impact on a company’s balance sheet.
As a result, operating leases did not impact a company’s debt-to-equity ratio because no liabilities were included on the balance sheet along with the lease. This ability to leave a lease off of a balance sheet could make a company appear as though they were a better investment and had stronger financials than if the lease was classified as a finance lease.
The fact that operating leases were not documented on a firm’s balance sheet was a loophole that American companies had been using for years to improve their debt-to-equity ratios and other similar metrics frequently used by banks to determine loan covenants. Now, with ASC 842, both types of leases are required to be put on a company’s balance sheet, making this loophole obsolete.
However, the expense recognition pattern does differ for operating and finance leases. Operating lease accounting requires lease expenses to be recognized on a straight-line basis over the lease term, whereas finance leases (just like capital leases) require the lessee to recognize interest expense and amortization expense, which means expenses will be higher at the beginning of the lease and decrease over time.
What is the Journal Entry for Operating Lease?
Like we’ve said above, ASC 842 is a game-changer for lease accounting for U.S. firms. While the concepts of operating vs finance leases remain, any lease 12 months or longer is now required to be recorded on a balance sheet. This makes operating lease accounting more complicated for many firms.
With the new lease standard, operating lease initial journal entries will record a lease liability and right-of-use (ROU) asset onto the balance sheet. Ongoing operating lease journal entries will record a lease expense as usual, as well as reducing the lease liability and ROU asset balance over the life of the lease.
Do Operating Leases Go on the Balance Sheet?
Operating leases used to not be documented on balance sheets, which is why U.S. firms often classified as many leases as possible as an operating lease. Now, under ASC 842, these leases are included on the balance sheet.
ASC 842 Operating Lease Example
How Software Can Help You With Lease Accounting
With these changes in lease documentation and the requirement of all leases to be documented on balance sheets, looking for methods and tools to ease into these new changes and make sure your company’s lease accounting is up to the new standards is a good way to adapt.
Utilizing LeaseCrunch is an optimal way to make sure your financial statements are compliant and that your leases are correctly categorized. A Top 100 CPA Firm, Brown Smith Wallace, began using LeaseCrunch for their lease accounting, client management, and reporting needs. They hail it as the best solution available for lease accounting because our software offers:
- Speed: companies implement our software fast, and our software performs calculations even faster.
- Ease of use: Easily create journal entries and footnote disclosures with a few clicks.
- Accuracy and Compliance: Validation checks are integrated into our software to ensure data input accuracy and compliance with standards.
- Exports into Spreadsheets: We get it, what we know is what’s comfortable. That’s why we offer exports into Excel to give you your daa in the formatting that is best for your business and procedures.
After learning about the changes in lease accounting, let us handle the increase in complications so you can stay compliant and focused on your business. Interested in a worry-free lease accounting experience and want a demo? Contact us today to get started.