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CPA/FAR/Leases (ASC 842)

Leases (ASC 842)

Lessee finance vs operating leases, right-of-use assets, and lease liability measurement.

Hard 1 hr 30 minArea II: Select Balance Sheet Accounts

Lessee accounting: almost everything is on the balance sheet now

Under ASC 842, lessees recognize a right-of-use (ROU) asset and a lease liability for virtually all leases longer than 12 months — the old "operating lease = off-balance-sheet" treatment is gone. What survives from the old model is the income statement distinction between finance and operating leases.

Classification: finance vs. operating (lessee)

A lease is a finance lease if any one of these five criteria is met (otherwise it's operating):

  1. Ownership transfers to the lessee by the end of the lease term
  2. The lease contains a purchase option the lessee is reasonably certain to exercise
  3. The lease term is for the major part of the remaining economic life of the asset
  4. The present value of lease payments equals or exceeds substantially all of the asset's fair value
  5. The asset is so specialized it has no alternative use to the lessor at the end of the term

IMPORTANT: Both finance and operating leases put a ROU asset and lease liability on the balance sheet, measured identically at commencement (PV of lease payments). The difference is in subsequent measurement and expense pattern.

Subsequent accounting

Finance leaseOperating lease
Interest expenseSeparate, effective-interest on liabilityCombined into single lease expense
ROU amortizationSeparate, typically straight-lineCombined into single lease expense
Expense patternFront-loaded (higher total expense early)Straight-line (constant total expense)

EXAMPLE: For an operating lease, total lease expense is recognized on a straight-line basis over the lease term, even if cash payments escalate — the ROU asset amortization is simply the difference between the straight-line expense and the interest accretion on the liability each period.

EXAM TIP: Short-term leases (12 months or less, no purchase option reasonably certain to be exercised) are exempt — lessees can elect to keep them off the balance sheet and expense payments straight-line, similar to old operating-lease treatment.