- What is an operating lease?
- Finance/capital lease vs. operating lease criteria
- Operating lease accounting under ASC 842 - Example with LeaseGuru
What is an operating lease?
An operating lease is similar to a rental agreement. A lessee is granted the right to use the lessor’s asset for a specified period that is less than the useful life of the asset. The lessee agrees to make payments totaling less than the fair value of the asset, for the right to use the asset. Upon the end of the agreed-upon term, the lessee does not own nor have the option to purchase the asset.
Leases are classified in two different ways under both ASC 840 and ASC 842. The term operating leases exist in both standards, even though the accounting treatment is different in each standard. The capital lease classification under ASC 840 changed to the terminology finance lease in ASC 842, but the accounting is consistent for this classification between the two standards.
Finance/capital lease vs. operating lease criteria
ASC 840 designated two types of leases: operating and capital.
ASC 842 still designates two types of leases: operating and finance. One of the changes implemented with ASC 842 is the renaming of capital leases to finance leases. While this is mostly a nomenclature change to provide more clarity to the different types of lease commitments, key differences in how a lease is classified under ASC 840 vs. ASC 842 do exist.
Previously, only four criteria were used to determine if a lease was a capital lease for the lessee. Now, there are five criteria to consider for finance leases (ASC 842-10-25-2):
- Transfer of title/ownership to the lessee
- A purchase option the lessee is reasonably certain to exercise
- The lease term is over a major part of the economic life of the asset
- Present value equals or exceeds substantially all of the fair value of the asset
- Asset specialization: Would it provide any value to the lessor after the lease term?
If a lease does not meet any of the five criteria, it is an operating lease.
When accounting for an operating lease, the lessee must:
- Recognize a single lease cost allocated over the lease term, generally on a straight-line basis
- Classify all cash payments within operating activities on the statement of cash flows
Operating lease accounting under ASC 842 - Example with LeaseGuru
Below is an example of the accounting for an operating lease beginning post-transition. For the example, let’s assume the following facts:
- Start Date: 1/1/2023
- End Date: 12/31/2026
- Payment terms: $20,000 annually, at the beginning of the period
- Incremental Borrowing Rate (IBR): 3%
- The lessee determines this is an operating lease
Enter the information into LeaseGuru in the appropriate fields, shown below:
- Start Date: 1/1/2023
- End Date: 12/31/2026
- Payment terms: $20,000 annually, at the beginning of the period
- Incremental Borrowing Rate (IBR): 3%
- The lessee determines this is an operating lease
Based on these assumptions, LeaseGuru returns a present value of 4 annual payments of $20,000, made in advance, with a 3% IBR of $76,524*. The annual operating lease expense is $20,000, or the straight-line treatment of 4 annual payments with no escalations, rent holidays, etc. A portion of the amortization schedule generated by LeaseGuru and a reconciliation to the initial lease liability and ROU asset for this lease is below.
The amortization schedule shows the net activity for the first month and does not split out the beginning balance for the lease liability and ROU asset. Those amounts are calculated below:
LeaseGuru generates the following net journal entry for January 2023, combining the initial entry to record the lease liability and ROU asset and the payment and lease activity for the month.
Subsequent entries follow the amounts set forth in the amortization table. The entry for the activity in February of 2023 is below.