The Difference Between Calculating an Operating Lease and a Finance Lease Under ASC 842

Lucas Russell | 2021-01-01

Unlike ASC 840, where the difference between accounting for an operating lease and a capital lease couldn't be more different, under ASC 842, the accounting for an operating lease and the now called finance lease, which has replaced the name capital lease, is similar, but not exact. 

No matter the classification, the lease is captured on the balance sheet with a right of use asset and a lease liability. For operating leases transitioning to ASC 842, this is a significant change from the accounting of an operating lease under ASC 840. 

From a capital lease perspective, the accounting under the new lease standard ASC 842 is relatively similar to ASC 840. Under ASC 842, there have been some terminology changes. For example, capital leases are now referred to as finance leases. A leased asset is now the right of use asset. Nevertheless, the fundamental accounting of the present valuing the future lease payments and recognizing a liability and asset has not changed. 

Suppose you're starting from scratch and not familiar with the accounting of a capital lease under ASC 840 and the concept of calculating the present value. In that case, I'd recommend you read the following articles: 

  • How to Calculate the Present Value of Future Lease Payments
  • How to Calculate a Daily Lease Liability Amortization Schedule in Excel
  • How to Calculate the Lease Liability and Right-of-Use Asset for an Operating Lease under ASC 842
  • Lease Accounting Transition Guide from ASC 840 to ASC 842

Once you're confident with the concept of present valuing a lease liability and how the right of use asset is calculated, you're ready for this article. The article's objective is to highlight the areas where the accounting between a finance lease and an operating lease diverges. The differences in accounting start with the lease calculations and affect everything after that, such as the journal entries, financial statement classifications, and disclosures.

The lease classification test remains

Like ASC 840, the new lease accounting standard ASC 842 requires when a contract is within the scope of the standard, a classification must be made to determine if the lease is an operating or finance lease. To clarify, a finance lease is a capital lease under ASC 840 speak. 

Criteria to decide if it's an operating or finance lease

From a lessee perspective, a lease that meets one or more of the criteria in paragraph 842-10-25-2 is considered a finance lease. 

842-10-25-2 states

A lessee shall classify a lease as a finance lease, and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:

a. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

b. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

c. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.

d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.

e. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

If you've met one of the above criteria, you have a finance lease. If not, the lease classification defaults to an operating lease. 

Note the standard has a practical expedient to carry forward all classifications made under ASC 840, so there's no need to perform the reassessment. 

The difference in calculations between an operating and finance lease

So you've made the classification distinction between an operating lease and finance lease, now what? 

Under the new standard, the accounting for both an operating lease and finance lease follow very similar principles. Unlike under ASC 840, where you'd much rather it be an operating lease from a simplicity of accounting perspective, that sentiment no longer exists. If anything, under ASC 842, a finance lease has the more straightforward accounting. 

Both classifications result in the lease coming on the balance sheet. No matter the classification, a lease liability and right of use asset are recognized. Furthermore, the calculation of the lease liability is identical given it's the present value of known future cash flows. This is consistent throughout the life of the lease and modification accounting. 

As a result, the initial recognition of both the two classifications is identical. It's day 2, where the accounting diverges. 

The calculation of the lease amortization

First of all, technically, for an operating lease, it's the "lease expense." This expense represents the decline in value of the right of use asset during the lease term. 

The calculation of amortization for a finance lease is very straightforward. It's a straight line amortization calculation. You do not have to use a straight-line basis if there is another systematic basis that is more representative of the pattern in which the lessee expects to consume the right-of-use asset's future economic benefits. Assuming you're going to use a straight-line method, it's the initial recognition value of the right of use asset divided by the useful life, and that's your amortization expense. If you want a practical example, refer to the article How to Calculate the Right-of-Use Asset and Lease Liability for a Finance Lease under ASC 842

With an operating lease, the amortization calculation is not as intuitive, and there are two ways you can calculate the expense. There's even a caveat to these methods. If there's been an impairment of the right of use asset, everything changes, which we'll touch on later. 

To calculate the "amortization"/lease expense, you have two methods available: 

Method 1:

Method 1 of calculating the operating lease amortization under ASC 842

Method 2:

Method 2 of calculating the operating lease amortization under ASC 842

Amortization is calculated as the difference between the straight-line lease cost for the period (including amortization of initial direct costs) – and the periodic accretion of the lease liability using the effective interest method. Method 1 may not be practicable for entities other than those with a smaller volume of relatively straightforward leases. For an in-depth example of calculating the amortization using Method 2, refer to the article How to Calculate the Lease Liability and Right-of-Use Asset for an Operating Lease under ASC 842

Impairment of an operating lease

ASC 842-20-25-7 states the After a right-of-use asset has been impaired in accordance with paragraph 842-20-35-9, the single lease cost described in paragraph 842-20-25- 6(a) shall be calculated as the sum of the following:

a. Amortization of the remaining balance of the right-of-use asset after the impairment on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the remaining economic benefits from its right to use the underlying asset.

So the standard then tells you, ok, after an impairment, you can do it the same way as a finance lease after all! 

It's almost like they've purposely made the standard more complicated for you. If you don't have time to learn these nuances but do not want to compromise the integrity of your financial reporting, use Cradle, we'll do the rest ;) 

A single lease expense

If the lease is classified as an operating lease, there's only one type of expense that hits the income statement "lease expense." As a result, the lease liability's interest is classified as a "lease expense." The way the interest is calculated does not change. The amortization expense for an operating lease is also classified as a lease expense. For an example of how to calculate the lease expense for an operating lease, refer to How to Calculate the Lease Liability and Right-of-Use Asset for an Operating Lease under ASC 842

With a finance lease, there's an interest expense and an amortization expense. To highlight this difference, the below chart compares the difference between the income statement impact of an operating lease and a finance lease. 

Comparison between the impact a finance lease and operating lease has on the income statement under ASC 842

Cashflow statement

The lease classification also impacts how the actual cash outflow of payments is classified within the cash flow statement. For an operating lease, all payments are classified as operating cash flows, simple enough.

Whilst for a finance lease, the standard states for cash paid, you should disclosure those cashflows between operating and financing. Generally, the payment attributed to interest is seen as a financing cash outflow, whilst the principle payments can be classified as operating. This is one area of compliance many companies fall short on because of the required amount of work required to calculate the principal and interest portion of the payment.

Again using Cradle, this will be done in seconds :)

Conclusion

The key takeaways here are:

  • There's no difference in the lease liability calculation
  • Amortization calculation is tricky with an operating lease
  • Interest and amortization are classified as a lease expense on the income statement for an operating lease. 
  • With the cash flow statement, operating lease payments are operating cash flows. For a finance lease, it's required to segregate between operating and financing cash flows.

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