The Financial Accounting Standards Board changed the lease accounting game forever when they declared the ASC 842 new lease accounting standard. 

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?”.

Finance Leases

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 a finance lease. For example, if the present value of 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

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 criteria 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, operating leases were expensed over a straight-line basis with a deferred rent amount 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?

The previous lease standard considered four criteria for classifying a lease as capital vs. operating. Under the new lease standard, one additional criteria has been added.

To be classified as a finance lease, at least one of the following criteria must be true:

• Ownership of the asset transfers to the lessee at the end of the lease term.
• 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 term.
• The lease term is a major part of the economic life of the underlying asset (75% was the previous bright line test. FASB states this is an acceptable approach, so 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. FASB states this is an acceptable approach, so most organizations continue to use this to determine “substantially all”).

What is an Operating Lease?

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 vs. 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 Balance Sheet. Prior to ASC 842, operating leases were not added to the Balance Sheet as ROU Assets and Lease Liabilities.

As a result, operating leases did not impact a company’s debt-to-equity ratio because no operating lease liabilities were included on the balance sheet along with the leased asset. 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 added to the Balance Sheet, which is what the FASB hoped to adjust with the publication of ASC 842.

It is important to note that the expense recognition pattern does differ for operating and finance leases. Operating lease expense is determined by dividing total lease payments over the lease term whereas finance leases (just like capital leases) require the lessee to amortize the ROU Asset over either the lease term or useful life of the asset—whichever is longest—and record interest expense on the remaining lease liability.

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. companies following GAAP. 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 when the policy election is made to exclude applying the standard to short term leases. This makes operating lease accounting more complicated for many organizations.

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 lease term.

Do Operating Leases Go on the Balance Sheet?

Under previous lease accounting, operating leases were not documented on balance sheets in the form of lease liabilities and ROU Assets. Now, under ASC 842, these operating lease liabilities and ROU Assets are included on the balance sheet.

ASC 842 Operating Lease Example

For an example of how operating lease accounting is performed in accordance with the new standard, check out this article by the CPA Journal.

How Software Can Help You With Lease Accounting

With these changes to the lease standard  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:

1. Speed: companies implement our software fast, and our software performs calculations even faster.
2. Ease of use: Easily create journal entries and footnote disclosures with a few clicks.
3. Accuracy and Compliance: Validation checks are integrated into our software to ensure data input accuracy and compliance with standards.
4. 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.

FAQ’s

Why is operating lease better?

It used to be the case that operating leases did not impact a company’s debt-to-equity ratio because no operating lease liabilities were included on the balance sheet. However, since the advent of ASC 842, this is no longer the case. 

What are the 5 criteria for finance vs. operating lease?

In order for a lease to be considered a finance lease, the following must be true:

1. A transferral of ownership occurs at the end of the term of the initial lease.
2. The lessee is reasonably certain that they will exercise a purchase option at the end of the term of the lease.
3. The leased asset has no alternative use to the lessor at the end of the lease.
4. The lease term is a major part of the economic life of the underlying asset 
5. The present value of lease payments is substantially all of the fair value of the leased asset

How to tell if a lease is an operating lease

A lease is an operating lease if it does not meet the five requirements of a finance lease.

What is the 90% rule for operating leases?

The 90% rule is one of the criteria used to classify leases as operating or finance. If the present value of future lease payment is substantially all, or 90% of the fair value of the leased asset, then the lease is not an operating lease.