When adopting ASC 842 lease accounting standards, companies often struggle to distinguish between operating and finance leases.
By understanding the 5 criteria for classifying leases and walking through practical examples, you can confidently evaluate leases and ensure accurate financial reporting.
In this post, we'll break down the key differences between operating and finance leases under ASC 842, including the classification criteria, accounting treatments, and real-world examples to guide your adoption.
Introduction to Capital Leases vs Operating Leases Under ASC 842
The new ASC 842 guidelines have brought significant changes to lease accounting standards. Under the previous rules, operating and capital leases were accounted for very differently on the balance sheet and income statement. However, ASC 842 aims to increase transparency and comparability by requiring lessees to recognize a "right-of-use" asset and a lease liability on their balance sheets for most leases.
Understanding the Lease Classification Under ASC 842
The key factor in classifying a lease under ASC 842 is whether it transfers control of the underlying asset to the lessee.
- Capital leases transfer control and ownership of the asset to the lessee. This means the lessee records the asset on its balance sheet along with a liability for future lease payments.
- Operating leases do not transfer control or ownership, so the lease payments are simply expensed on the income statement.
To determine if a lease transfers control, ASC 842 lays out 5 criteria for capital leases. If a lease meets any one of these, it would qualify as a capital lease.
Overview of ASC 842 Lease Accounting Standards
The FASB issued ASC 842 to increase transparency and comparability of lease obligations. Here are some of the major changes:
- Eliminates operating vs capital lease classification for lessees
- Requires recognition of a right-of-use asset and lease liability for most leases
- Changes the definition of initial direct costs, lease incentives, etc.
- Requires additional disclosures about leasing arrangements
- Retains similar standards for lessors
- Allows some practical expedients and policy elections
By recognizing lease assets and liabilities on the balance sheet, ASC 842 gives investors and creditors greater insight into a company's financial leverage and capital employed.
Impact of ASC 842 on Financial Reporting
Under ASC 842, both capital and operating leases now result in recording a right-of-use asset and lease liability. This leads to key impacts:
- Significantly higher assets and liabilities on the balance sheet
- Changes in key ratios like debt-to-equity due to higher liabilities
- Front-loaded total lease expense on the income statement
- Potential changes in lease vs buy decisions and negotiations
Overall, while ASC 842 introduces complexity, it creates a more accurate picture of a company's financial commitments and leverage. Careful planning and analysis will be key to smooth adoption.
Do capital leases exist under ASC 842?
Yes, capital leases still exist under ASC 842, but they are now referred to as "finance leases."
The key criteria that qualify a lease as a finance lease under ASC 842 are largely unchanged from the previous capital lease criteria under ASC 840. According to FASB Accounting Standards Update No. 2016-02, a lease would qualify as a finance lease if it meets any one of the following criteria:
- Transfer of Ownership - The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- Bargain Purchase Option - The lease contains a bargain purchase option allowing the lessee to purchase the asset for an amount significantly lower than the expected fair value at the date the option becomes exercisable.
- Majority of Economic Life - The lease term covers 75% or more of the remaining economic life of the underlying asset. However, if the beginning of the lease term falls within the last 25% of total economic life, this criterion shall not be used.
- Present Value Test - The present value of the sum of lease payments equals or exceeds 90% of the fair value of the underlying asset.
The key difference under ASC 842 is that these criteria must be applied at lease commencement rather than lease inception, allowing for some changes in classification during the lease term.
So in summary - yes capital leases still exist under ASC 842, they are just referred to as "finance leases" now. The key criteria are largely the same with some tweaks to the timing of evaluation.
What is difference between operating lease and capital lease?
The key differences between an operating lease and a capital lease under ASC 842 are:
Capital Lease Criteria
A lease is classified as a capital lease if it meets any one of the following criteria:
- Transfer of Ownership: The lease transfers ownership of the asset to the lessee by the end of the lease term
- Bargain Purchase Option: The lease contains a bargain purchase option allowing the lessee to buy the asset for less than fair market value
- Majority of Useful Life: The lease term is for the major part of the remaining economic life of the underlying asset
- Present Value: The present value of the lease payments equals or exceeds substantially all of the fair value of the underlying asset
Operating Lease
A lease that does not meet any of the capital lease criteria is classified as an operating lease.
Key features of operating leases:
- Shorter lease term
- Total lease payments are less compared to asset value
- Lessee does not gain ownership at end of lease
- Lessor bears risk of obsolescence/residual value
Key Differences
- Asset Ownership: Capital leases transfer asset ownership, operating leases do not
- Expense Treatment: Capital lease expenses are front-loaded, operating lease expenses are straight-lined
- Financial Reporting: Capital leases recognized on balance sheet, operating leases are not
In summary, capital leases effectively act as a financed asset purchase while operating leases are true rentals. Understanding the differences is key for proper accounting treatment and financial reporting under ASC 842.
What are the two types of leases under ASC 842?
Under ASC 842, there are two main types of leases that organizations need to classify:
Operating Leases
- Lease does not transfer ownership of the underlying asset to the lessee
- Lease term is less than 75% of the economic life of the leased asset
- Present value of lease payments is less than 90% of fair value of leased asset
Finance Leases
- Lease transfers ownership of the underlying asset to the lessee
- Lease term is 75% or more of the economic life of the leased asset
- Present value of lease payments is 90% or more of fair value of leased asset
To summarize, operating leases are similar to renting, while finance leases are more akin to buying on installment. Organizations need to assess their leases based on the criteria above to determine if they should be classified as operating or finance leases.
Despite this difference in classification, ASC 842 requires both types of leases over 12 months in length to be recorded on the balance sheet rather than expensed on the income statement. This aims to increase transparency into lease obligations.
sbb-itb-beb59a9
How do operating leases differ from capital leases?
Operating and capital leases have key differences in how they are recorded on a company's financial statements. Here is an overview:
Ownership
In a capital lease, the lessee takes on substantially all the risks and rewards of ownership of the leased asset. At the end of the lease term, the lessee often has the option to purchase the asset for a nominal price, meaning they retain effective ownership.
In an operating lease, the lessor retains ownership of the asset and the lessee does not have an option to purchase it at the end of the lease term. The lessor assumes the risks and rewards of ownership.
Asset Recording
Under capital leases, the lessee records the leased asset on its balance sheet along with a liability for future lease payments. As the lessee makes lease payments, part of the payment reduces the lease liability and part is recognized as interest expense.
With operating leases, the lessee does not record the leased asset on its balance sheet. Lease expense is recorded on a straight-line basis over the lease term, meaning the total lease expense is allocated evenly to each period.
Financial Ratios
Capital leases increase assets and liabilities on the balance sheet, while operating leases do not. This impacts financial ratios like debt-to-equity. Most companies prefer to structure leases as operating to keep their ratio metrics within target thresholds.
So in summary, capital leases transfer substantially all ownership risks/rewards to the lessee, whereas operating leases do not. This changes how leases are recorded and impacts financial statements.
Criteria for Lease Classification Under ASC 842
ASC 842 provides new guidance for classifying leases as either capital or operating. There are 5 key criteria that must be assessed:
5 Criteria for Finance Lease Classification
To be considered a finance lease under ASC 842, a lease must meet any one of the following criteria:
- Ownership Transfer: The lease transfers ownership of the asset to the lessee by the end of the lease term
- Purchase Option: The lease contains an option for the lessee to purchase the asset that they are reasonably certain to exercise
- Lease Term: The lease term makes up a major part (75% or more) of the remaining economic life of the underlying asset
- Useful Life: The present value of the sum of lease payments equals or exceeds substantially all (90% or more) of the fair value of the underlying asset
- Present Value: The present value of the lease payments equals or exceeds substantially all of the fair value of the underlying asset
If none of the above criteria are met, the lease is classified as an operating lease.
Capital Lease vs Operating Lease Under ASC 842 Examples
Here are some examples of applying these classification tests:
- A 5-year lease of equipment with an estimated useful life of 7 years would be a capital lease, since the lease term represents over 75% of the asset's useful life.
- A 3-year lease with monthly payments that have a present value equal to 80% of the asset's fair value would be an operating lease under ASC 842, since the 90% threshold for present value is not met.
- A lease with a $1 purchase option at the end that the lessee is reasonably certain to exercise would be a capital lease, as the purchase option criteria is satisfied.
The implications of lease classification on financial reporting are:
- Capital leases are treated similarly to purchased assets, recorded on the balance sheet with depreciation expense.
- Operating leases are kept off the balance sheet with lease payments expensed on a straight-line basis.
Evaluating Lease Terms Against Generally Accepted Accounting Principles
The thresholds for lease term and present value under ASC 842 differ from previous GAAP standards. For example, the 75% threshold for lease term consideration and 90% threshold for present value are stricter than previous rules.
As a result, some leases that may have qualified as operating leases before may now meet the criteria for capital leases under ASC 842. This means that more lease obligations will appear on lessee's balance sheets, increasing their debt-to-equity ratios.
The updated guidance moves towards reflecting the economic substance of lease transactions, providing investors and stakeholders a more accurate picture of a company's obligations. However, it also introduces additional complexity for accounting and financial reporting.
Accounting Treatment for Capital and Operating Leases
Capital and operating leases are accounted for differently under ASC 842. This section will summarize some key differences.
Recognizing Leases on Balance Sheets
- Capital leases are recognized on the balance sheet as assets and liabilities, similar to purchased assets. This increases assets and liabilities on the balance sheet.
- Operating leases are not recognized on the balance sheet. There is off-balance sheet disclosure of future lease payments in the financial statement footnotes.
- Capital leases increase debt obligations, while operating leases do not. This can impact financial ratios like debt-to-equity.
Depreciation and Amortization on a Straight-Line Basis
- Assets under capital leases are depreciated over the shorter of useful life or lease term, impacting depreciation expense.
- Operating lease payments are expensed on a straight-line basis over the lease term as rental expense. There is no depreciation.
Ongoing Compliance with ASC 842
- For capital leases, compliance involves tracking depreciation of lease assets and interest/principal payments on lease liabilities.
- Operating leases mainly require disclosure of future lease payments and supplemental non-GAAP metrics in financial statement footnotes.
Practical Examples: Operating Lease vs Finance Lease Under ASC 842
This section will provide a detailed comparison of accounting for operating leases and finance leases with practical examples.
Operating Lease vs Finance Lease ASC 842: A Comparative Analysis
Under ASC 842, the key criteria for classifying a lease as a finance lease are:
- Transfer of Ownership: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- Purchase Option: The lease contains an option for the lessee to purchase the asset that they are reasonably certain to exercise.
- Lease Term: The lease term makes up a major part (75% or more) of the remaining economic life of the leased asset.
- Present Value: The present value of the lease payments equals or exceeds substantially all (90% or more) of the fair value of the leased asset.
In contrast, operating leases do not meet any of the above criteria. The key differences in accounting treatment are:
Operating Lease
- Lease payments are expensed on a straight-line basis over the lease term.
- Assets and liabilities are not recorded on the balance sheet. Only future minimum lease commitments are disclosed in the footnotes.
Finance Lease
- Lessee records a "right-of-use" asset and lease liability at present value of future payments.
- Depreciation expense is recorded on a straight-line basis for the right-of-use asset, along with interest expense on the lease liability over the lease term.
For example, a 5-year equipment lease with annual payments of $20,000 and a bargain purchase option of $5,000 at the end would likely qualify as a finance lease. The lessee would record a right-of-use asset and lease liability of $83,000 at lease commencement, depreciating it over the 5 year term with interest expense on the liability each period.
An operating lease for the same asset would simply expense the $20,000 each year with no asset/liability on the books.
ASC 842 Finance Lease Example: Accounting Entries and Reporting
Here is a step-by-step example of accounting for a finance lease under ASC 842:
Lease Terms:
- Asset Fair Value: $100,000
- Annual Lease Payment: $25,000
- Lease Term: 4 Years
- Incremental Borrowing Rate: 6%
Lease Classification Test:
- Present Value of Payments: $83,952 ($25,000 x 3.758 PV factor at 6%)
- 90% of Fair Value: $90,000
Since the present value exceeds 90% of fair value, this lease qualifies as a finance lease.
Initial Measurement and Entries
- Lease Liability = $83,952
- Right-of-Use Asset = $83,952
Entry at Lease Commencement:
Right-of-Use Asset: $83,952
Lease Liability: $83,952
The right-of-use asset is depreciated straight-line over the 4 year lease term, while interest expense is recorded on the lease liability each period.
On the balance sheet, the asset and liability are presented separately from owned PP&E and debt. The amortization schedule and future minimum lease commitments are disclosed in the footnotes.
Calculating Present Value and Assessing Bargain Purchase Options
To determine if a lease meets the 90% present value threshold, the lessee first calculates the present value of the lease payments using the rate implicit in the lease or their incremental borrowing rate.
For example, if a 3 year lease has annual payments of $30,000 and the lessee's incremental rate is 5%, the present value would be $83,343 ($30,000 x 2.778 PV factor). If the asset fair value is less than $92,593 (90% of $83,343), the lease would qualify under the ASC 842 finance lease rules.
Bargain purchase and fixed price purchase options also need special consideration, as they allow the transfer of ownership to the lessee. If the lessee is reasonably certain they will exercise such an option, the lease meets the finance lease criteria.
Transitioning to ASC 842: Steps and Strategies
Evaluating Current Leases Under ASC 842
To determine if existing leases meet the criteria for capital or operating classification under ASC 842, companies should take the following steps:
- Review all lease agreements and gather key details like lease terms, payments, options to renew, purchase options, and more. This info is needed to assess the leases.
- Calculate the present value of lease payments to determine if it represents substantially all of the fair value of the asset. This is a key test for capital vs operating lease.
- Assess if the lease term is for the major part of the remaining economic life of the asset. Capital leases generally cover over 75% of the asset's life.
- Determine if the lease has a bargain purchase option at the end to acquire the asset. This would point towards a capital lease.
- Evaluate whether the specialized nature of the asset means it has no alternative use at the end of the lease term. Lack of alternative use suggests a capital lease.
By gathering this lease data and running through these capital lease classification tests, companies can determine if existing leases will be capital or operating under ASC 842.
Adopting Accrual Accounting for Lease Transactions
To maintain compliance with ASC 842 on an ongoing basis, companies should update their accounting policies, processes, and systems for lease transactions:
- Accounting Policies - Develop new capital vs operating lease policies aligned with ASC 842 criteria. Outline processes for lease data gathering, testing, and accounting treatment.
- Lease Management Processes - Implement controls around lease origination to ensure proper data collection for ASC 842 classification tests. Maintain centralized lease repository.
- Lease Accounting Systems - Configure ERP software to handle ASC 842 calculations for ROU assets, lease liabilities, interest expense, amortization, etc. Automate where possible.
- Subledger Reconciliation - Reconcile lease subledger to general ledger regularly. Perform audits to ensure accurate financial reporting under ASC 842.
Updating frameworks and systems for lease accounting is key to maintaining compliance as portfolios change post-adoption.
Summary and Next Steps for ASC 842 Compliance
Transitioning to ASC 842 requires detailed lease contract review and updated policies, processes, and accounting systems. By taking methodical steps to evaluate leases, implement lease accounting software, and build strong controls around origination data, companies can effectively meet ASC 842 guidelines on a sustainable basis. Regular subledger audits and policy reviews will also help ensure continued adherence to the new standards.
