Do you know what it’s like to spend hours studying to learn a topic to pass an exam, only to find you’ve forgotten it all the next day? Well, that was me when it came to lease accounting. It took some serious refreshing before I could account for leases in the real world. So, as any trained accountant or CPA knows, when you come to a question in accounting, you throw a Hail Mary and google it.
Well, here I am to catch your Hail Mary and help you get closer to the end zone when it comes to lease accounting. Specifically, I hope to help you better understand the typical journal entries found with an operating lease and a finance lease under ASC 842, as well as the financial statement impact of those journal entries. I will build on a brief article written by Adam Riches (CEO of Netgain) that concisely explains when to classify a lease as operating vs. finance and the high-level differences between those two lease classifications. In the downloadable file and below, I will show you the following:
- How to evaluate if a lease should be classified as an operating or financing lease—see Procedure #1 in the downloadable file, which includes a formula-driven tool to help you determine a lease classification.
- An amortization schedule that can be used for both an operating and financing lease—see below and Procedure #2 in the downloadable file.
- The journal entries that would be booked for each classification—see below and Procedure #3 in the downloadable file.
- The income statement and balance-sheet impact of each classification. See below and Procedure #3 of the downloadable file
1. An amortization schedule that can be used for both an operating and financing lease.
Under each lease classification, an amortization schedule will be required to easily capture the lessee journal entries for each month of the lease term. One amortization schedule can be used to extract the necessary information for both operating and finance journal entries. See Procedure #2 in the downloadable file for an example amortization schedule. The amortization schedule and the image through the remainder of this article are based on the following lease details:
2. The journal entries that would be booked for each classification (assuming a simple lease with no prepayments, initial direct costs or lease incentives).
Initial journal entries for both operating lease and finance leases will be the same:
- Credit Lease Liability—Present value of all future lease payment (discount rate used in calculation is your incremental borrowing rate “IBR”).
- Debit Right of Use (ROU) Asset—Equals your lease liability, unless prepayments, initial direct costs or lease incentives exist.
The monthly journal entries are the following for each classification:
- Debit Lease Expense—straight-line computation of all future lease payments. Computed as the sum of future lease payment divided by the lease term.
- Debit Lease Liability—Reduces lease liability. Computed as the lease payment, less the interest accretion for the period on the lease-liability balance.
- Credit ROU Asset Accumulated Amortization—Reduces ROU asset. Computed as the S/L lease expense, less the interest accretion on the lease liability balance for the period.
- Debit ROU Amortization Expense—S/L amortization over the term of the lease. Computed as initial ROU asset balance divided by the term of the lease.
- Credit ROU Accumulated Amortization—Equals your ROU amortization expense for the period.
- Debit Lease Liability—Decreases lease liability. Computed as the lease payment, less the interest expense on the lease liability balance for the period.
- Debit Interest Expense—Interest for the period on the running lease-liability balance.
- Credit Lease Payable (or cash)—Represents the lease payment required for the period.
3. The income statement and balance-sheet impact of each classification.Income Statement
- Lease expense is recorded within EBITDA.
- Lease expense will be consistent over the lease term.
- Interest and amortization are not recorded within EBITDA.
- The sum of the interest and amortization expense will be front-loaded, meaning the total expense will be larger early in the lease and lower toward the end, due to the nature of each period’s expense calculations.
- EBITDA is larger with a finance lease.
- Because of the front-loaded expense with a finance lease, operating leases present a larger net income early in the lease term relative to a finance lease and then a lower net income relative to a finance lease later in the lease term.
- Net ROU asset on the BS is larger early in lease term with an operating lease. The opposite is true later in the lease term. This is because the finance lease S/L amortizes the ROU asset through the lease term while the operating lease amortizes by taking the lease expense less the interest accretion for the period. The interest accretion is greater early in the lease term because of a larger lease liability balance early on, thereby making the amortization smaller early in the lease term for an operating lease.
Congratulations, you’ve made it through some very exciting material! Remember that the largest difference between the lease classifications is where the expense hits the income statement, especially the impact on EBITDA. If EBITDA is an important metric at your company, then you might want to consider structuring your lease agreements to be primarily finance-type leases.