Understanding Finance Lease vs Operating Lease: A Comprehensive Overview

By Black Owl Systems

The ever-evolving world of accounting has witnessed a plethora of changes, particularly for finance lease vs operating lease in lease accounting in lease accounting. With the introduction of the ASC 842 accounting standard by the Financial Accounting Standards Board, organizations have had to revisit their understanding and practices surrounding finance and operating leases. At Black Owl Systems, we aim to provide clarity on this crucial topic to ensure that businesses navigate these changes seamlessly.

A New Era of Lease Accounting: History of ASC 842

ASC 842 has superseded the older GAAP standard, ASC 840. This transformative move has modified how leases are recognized, classified, and thus influences lease accounting dynamics. The primary shift to note is the renaming of “capital leases” to “finance leases”. Despite this nomenclatural alteration, the accounting principles behind capital-now-finance leases have remained consistent. On the other hand, operating leases, while retaining their name, now find recognition differently than before.

Distinguishing Finance Leases

Under the lens of ASC 842, finance leases are those that closely resemble a purchase agreement for the underlying asset. A lease can be classified as a finance lease if it meets any one of the following five criteria:

  • Ownership Transfer: The lease agreement ensures a transferral of the asset’s ownership to the lessee once the lease term concludes.
  • Purchase Option: There is a significant likelihood that the lessee will exercise an option to purchase the asset at the end of the lease term.
  • No Alternate Use: At the conclusion of the lease term, the asset cannot be used by the lessor for any alternate purpose.
  • Lease Duration: The lease’s duration is considerably long, often occupying a significant part of the asset’s economic lifespan. Historically, a lease covering 75% of the asset’s economic life was a benchmark, and this remains a common reference point.
  • Payment Value: The present value of the lease payments amounts to almost the entirety of the asset’s fair value. While 90% was the conventional threshold, this is still widely adopted to define “substantially all”.

The Nature of Operating Leases

Operating leases differ fundamentally from finance leases in that they don’t simulate an asset purchase. Distinct features of an operating lease include:

  • No transfer of ownership at the lease term’s end.
  • The leased asset can be allocated to another party post-lease.
  • The lease doesn’t meet any of the finance lease criteria mentioned earlier.

Historically, operating leases were simply expensed, and there was no obligation to reflect the associated asset or liabilities on the balance sheet. However, ASC 842 mandates the inclusion of both the asset and liability of an operating lease on financial statements.

Finance Lease vs Operating Lease: Which Is More Advantageous?

The primary allure of leases lies in the lessee’s ability to leverage an asset without outright ownership, simultaneously providing the lessor an avenue for profitability.

In the pre-ASC 842 era, the allure of operating leases stemmed from their exclusion from balance sheets. This omission allowed firms to project better debt-to-equity ratios and financial health. However, ASC 842 has rendered this advantage redundant, necessitating that both lease types appear on the balance sheet.

Yet, the expense recognition pattern remains divergent. Operating lease expenses are recognized linearly throughout the lease term, while finance leases necessitate recognition of both interest expense and amortization expense, leading to front-loaded expenses which gradually taper off.

Navigating ASC 842: Journal Entries for Operating Leases

The ASC 842 directive is unequivocal — any lease spanning more than 12 months must feature on a balance sheet. Consequently, initial journal entries for an operating lease under ASC 842 should record both a lease liability and a right-of-use (ROU) asset. As the lease progresses, businesses should chronicle the regular lease expense and concurrently diminish the ROU asset and lease liability over the lease’s duration.

Conclusion

The landscape of lease accounting is undeniably intricate. With standards like ASC 842 ushering in foundational shifts, it’s paramount for businesses to be adept and informed. At Black Owl Systems, we’re committed to offering insights and guidance to ensure your organization remains at the forefront of accounting excellence.

Greg Kautz
Greg Kautz

Greg Kautz, CPA, CMA

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