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.
- Understand the differences between operating and financing leases and how to evaluate which type of lease to use
- Use an amortization schedule to easily capture the lessee journal entries for each month of the lease term
- Initial journal entries for both operating lease and finance leases will be the same
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.
How do you record an operating lease in accounting?
Under accounting standards such as IFRS and US GAAP, operating leases are recorded differently from finance leases. When a company enters into an operating lease agreement, the lease payments are treated as an expense on the income statement and the leased asset is not recorded on the balance sheet.
Instead, the lease obligation is disclosed in the footnotes of the financial statements. The expense is recognized on a straight-line basis over the lease term, which means that the total lease payments are spread out evenly over the lease term. This is calculated by dividing the sum of alllease payments by the number of periods in the lease term.
Where can I record an operating lease?
If you are a lessee, you should record an operating lease on your company's balance sheet as a right-of-use asset and a lease liability. The right-of-use asset represents the lessee's right to use the leased asset, and it should be recorded at the present value of the lease payments over the lease term.
The lease liability represents the lessee's obligation to make lease payments over the lease term, and it should also be recorded at the present value of the lease payments.
Who is the lessee and lessor in operating lease journal entries?
In an operating lease, the lessee is the party who obtains the right to use an asset from the lessor in exchange for periodic lease payments. The lessor is the party who owns the asset and leases it out to the lessee. The lessee records rental payments as expenses in the book of accounts. In contrast, the lessor records the property as an asset and depreciates it over its useful life.
Do you record interest on an operating lease?
No, interest is not recorded on an operating lease. When a lease is classified as operating, such as when no ownership transfer occurs at the end of the lease term, interest expense is not separately recognized and is instead incorporated into period rent expense and lease asset amortization.
What is included in lease operating expense?
Lease operating expenses typically include property taxes, insurance, security, cleaning and janitorial services, maintenance, utilities, and other related expenses. It's important to note that not all of these expenses will be applicable to every lease, and the specific lease operating expenses will be outlined in the lease agreement between the landlord and tenant.
Do you include lease liabilities in total debt?
Yes, lease liabilities are included in total debt. In accounting, lease liabilities arise from operating leases and finance leases. These liabilities are recorded on the balance sheet as obligations that the company owes to its lessors for the use of leased assets.
The amount of the lease liability is based on the present value of the future lease payments, and it is typically reported as a long-term liability. Since lease liabilities represent a company's obligation to pay future lease payments, they are considered a form of debt and are typically included in the calculation of total debt.
When should operating leases be capitalized?
Leases should be capitalized when they meet certain criteria, such as having a lease term of more than 12 months, having transfer of ownership rights at the end of the lease term, and having the right to an extension of the lease.
If none of these criteria are met, the lease can be treated as an operating lease, and the lease payments can be expensed as incurred. However, it's important to note that the criteria for capitalizing a lease may differ based on the accounting standards used (GAAP vs IFRS).
Are interest expenses debits or credits?
Interest expenses are debited to the account. Debit entries are used to record increases in expenses, assets, and losses, while credit entries are used to record increases in income, debt, or equity. Since interest expenses represent a cost to the company, they are recorded as a debit.
How are leases recorded on financial statements?
Leases are recorded as liabilities on the balance sheet and as operating expenses on the income statement. Historically, for operating leases under ASC 840, the leased asset is not recorded on the lessee's balance sheet. Instead, the lease payments are recognized as an expense on the income statement over the lease term.
However now under ASC 842, both Operating and Financing leases will appear on the Balance Sheet as an ROU Asset with an associated Lease Liability, and a related expense(s) on the income statement. You may note Short Term/Low Value leases and Subleases as being exceptions to this rule.
Do operating leases have ROU Assets?
Yes, operating leases have ROU (Right-of-Use) assets. In fact, the introduction of the new lease accounting standard, ASC 842, requires that operating leases be recognized on a company's balance sheet as ROU assets and corresponding lease liabilities. Prior to the adoption of ASC 842, operating leases were typically disclosed only in the footnotes of a company's financial statements.
However, under the new standard, companies are required to recognize these leases as assets and liabilities, which may significantly impact their financial position and key financial ratios.