Accounting for Leases in the United States: A Comprehensive Guide

In the United States, accounting for leases is governed by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) through ASC 842, Leases.

The FASB's ASC 842 standard requires lessees to recognize a right-of-use (ROU) asset and a lease liability on their balance sheet for all leases with terms longer than 12 months.

Lessee accounting for leases involves recognizing the ROU asset and lease liability at the lease's inception, and then depreciating the ROU asset and amortizing the lease liability over the lease term.

The ROU asset represents the right to use the underlying asset, while the lease liability represents the lessee's obligation to make lease payments.

In the United States, accounting for leases is governed by the Accounting Standards Codification (ASC) 842. This standard recognizes two types of leases for lessees: operating leases and finance leases.

Lessees must classify leases as either financing or operating leases, depending on certain criteria. A lease is classified as a finance lease if it meets any of the following criteria: it transfers ownership of the underlying asset to the lessee, grants the lessee an option to purchase the underlying asset, has a lease term that is for a major part of the remaining economic life of the underlying asset, has a present value of the lease payments and any residual value guarantees that equals or exceeds substantially all of the fair value of the underlying asset, or is of such a specialized nature that only the lessee can use it without major modification.

Under ASC 842, lessees must classify all other leases as operating leases. This approach to lease classification is a crucial distinction between ASC 842 and GASB 87, which uses a singular approach where no classification is necessary.

The standard recognizes three types of leases for lessors: operating leases, sales-type leases, and direct financing leases. Lessors must account for these types of leases differently, depending on the specific characteristics of the lease.

Here is a summary of the lease classifications under ASC 842:

For lessors, the standard recognizes three types of leases: operating leases, sales-type leases, and direct financing leases. These lease classifications are covered in ASC 842-30.

The scope of leases under ASC 842 is quite broad, but there are some specific types of leases that are exempt from the new standard. Leases of intangible assets, such as software subscriptions, are covered under ASC 350, Intangibles – Goodwill and Other.

Leases for the exploration or use of non-regenerative natural resources, like oil, natural gas, and minerals, are addressed in ASC 930 and ASC 932, respectively. Similarly, leases of biological assets, such as plants, animals, and timber, are covered in ASC 905, Agriculture.

Here are some specific lease types that are out of the scope of ASC 842:

A lease is a contractual agreement between two parties that gives one party the right to use an asset in exchange for a payment or series of payments.

The key judgment call under ASC 842 is determining if a contract is a lease or not, which is a critical decision that can have a material impact on a company's financial statements.

Under the new lease accounting standard, regardless of whether the lease is a finance or operating lease, it will be accounted for on the balance sheet.

A contract meets the definition of a lease if it transfers the right to use an asset, and this is the determining factor, not whether it's an operating or capital lease.

The lessee must determine if the lease is classified as operating or finance, with the classification criteria having slightly changed from ASC 840.

Under ASC 842, operating leases come on the balance sheet, requiring the lessee to calculate a lease liability, which is the present value of the future lease payments at a point in time.

The debit side of the journal entry is the right of use asset, which is calculated in conjunction with the lease liability.

To calculate the lease liability and right of use asset, refer to the example in the article, which also includes modification accounting and the calculation of ROU asset amortization expense.

Finance leases under ASC 842 are fundamentally the same as capital leases under ASC 840, with the lease continuing to be captured on a company's balance sheet.

The calculation of the lease liability is consistent between operating and finance leases, but the calculation of the right of use asset amortization differs.

With operating leases, interest and amortization are considered a "lease expense", whereas finance leases are accounted for differently.

The scope of leases is a crucial aspect of accounting for leases under ASC 842.

ASC 842 applies to the majority of leases and subleases, but some exceptions exist.

Leases of intangible assets, such as software subscriptions, are out of the scope of Topic 842 and are instead covered under ASC 350, Intangibles – Goodwill and Other.

Leases for the exploration or use of non-regenerative natural resources, such as oil, natural gas, and minerals, are covered under ASC 930, Extractive Activities – Mining, and ASC 932, Extractive Activities – Oil and Gas.

Leases of biological assets, such as plants, animals, and timber, are covered in ASC 905, Agriculture.

Inventory leases are addressed in ASC 330, Inventory.

Leases of assets under construction are covered in ASC 360, Property, Plant, and Equipment.

The key judgment call under ASC 842 is whether a contract meets the definition of a lease, rather than whether it's an operating or capital lease.

If a contract meets the definition of a lease, it will be accounted for on the balance sheet, regardless of whether it's a finance or operating lease.

There is a scope exemption provided by the standard setters for contracts that are for twelve months or less, which can be exempt from the balance sheet recognition model and expensed to the income statement.

Here are the out-of-scope lease types, as detailed in Subtopic 842-10-15-1:

For finance leases, lessees must recognize interest on the lease liability and amortization of the ROU asset in separate line items of the income statement. This is a straightforward requirement that's been in place since ASC 840.

To classify payments, the principal portion of the lease liability is classified within financing activities, while payments of interest on the lease liability are classified within operating activities on the statement of cash flows.

There's no need to adjust or remeasure existing capital leases under ASC 840, provided they were accounted for correctly. However, if there are any outstanding balances of deferred or prepaid rents at transition, these will need to be adjusted to the related ROU asset.

Here's a summary of the accounting treatment for finance leases:

As a lessor, you have different accounting options depending on the type of lease you offer. For operating leases, you continue to recognize the leased asset on your balance sheet, and income received from lease payments is recognized as rental income.

The key to classifying a lease as an operating lease is to ensure that none of the criteria for sales-type or direct financing leases are met. This includes not transferring ownership of the underlying asset to the lessee, not granting a purchase option, and not having a lease term that covers most of the asset's remaining economic life.

If you do meet any of these criteria, the lease is classified as a sales-type or direct financing lease, which requires derecognizing the leased asset and recognizing a net investment in the lease.

A direct finance lease is similar to a sales-type lease, but it also requires that the present value of lease payments and any residual value guarantee equals or exceeds substantially the fair value of the underlying asset, and that it's probable the lessor will collect lease payments plus amounts necessary to satisfy a residual value guarantee.

Here are the key differences between operating and sales-type/direct financing leases:

Overall, understanding the different accounting options for lessors can help you make informed decisions about your leasing activities and provide a more accurate financial picture of your business.

A finance lease is considered a finance lease if any of the following five criteria are met. The lease includes an option to transfer ownership of the underlying asset to the lessee by the end of the lease term.

To determine if a lease is a finance lease, you need to consider the lease term. If the lease term represents a major part of the remaining economic life of the underlying asset, it's likely a finance lease. This means the lease term covers 75% or more of the remaining economic life of the asset.

The present value of the lease payments and any residual value guaranteed by the lessee also plays a role in determining if a lease is a finance lease. If the present value equals or exceeds substantially all (generally 90% or more) of the fair value of the underlying asset, it's a finance lease.

The underlying asset's specialized nature can also be a factor. If the asset is of such a specialized nature it is expected to have no alternative use to the lessor at the end of the lease term, it's likely a finance lease.

Here are the five criteria for a finance lease:

The interest rate used to discount future payments is a critical factor in calculating the present value. This rate is based on the internal rate of return on all cash flows of the lease contract.

There are three ways to determine this rate. The first choice is to use the implicit rate used by the asset owner to set the lease rate. If this rate is not known, the second choice is to use the cooperative's marginal borrowing rate over the term of the lease.

This rate is subjective, but a logical approximation is all that is required. The marginal borrowing rate would be the interest rate that the cooperative would get if it borrowed the amount to purchase the asset it is leasing. Since leases are usually long-term, this rate would be higher than a variable rate or short-term loan and would be in addition to existing loans for equipment and other purposes.

If the first and second choice methods are not available, the cooperative can use a risk-free interest rate. This would be a U.S. Treasury bond rate over the term of the lease. Typically, this will be much lower than the first and second choice rates.

The rate chosen is important since the higher the rate, the lower the present value of the future payments, resulting in a smaller amount to be capitalized.

Here are the three methods to determine the interest rate:

Once the rate is set, it will not be changed later in the lease period even if market rates change significantly. The rate is assumed to be fixed for the term of the lease.

A finance lease is considered a finance lease if any of the five criteria are met. The criteria include ownership transfer, purchase option, lease term, present value, and specialized asset. If none of these criteria are met, the lease is classified as an operating lease.

To determine if a sale-leaseback transaction is a sale, refer to ASC 606, Revenue from Contracts with Customers. This type of transaction consists of both a sale and a lease.

When accounting for finance leases, lessees must recognize interest on the lease liability and amortization of the ROU asset in separate line items of the income statement.

The accounting treatment of a finance lease under ASC 842 is the same as the accounting that was required under ASC 840. Existing capital leases under ASC 840 do not require adjustment or remeasurement upon transition to ASC 842, provided they were accounted for correctly under ASC 840.

In a direct finance lease, the lessor derecognizes the leased asset and recognizes a net investment in the lease. The net investment in the lease consists of the unguaranteed residual asset plus the present value of future lease payments and any residual value guaranteed by the lessee.

For a finance lease, the lessee must recognize the lease liability and right-of-use asset on the balance sheet. The lease liability is the present value of the future lease payments at a point in time. The right-of-use asset is recorded as the debit side of the journal entry.

Here is a step-by-step example of capitalizing a lease:

The present value of the lease payments is $1,827,429. The lease liability is $1,827,429 as a long-term liability. The right-of-use asset is $1,824,429.