Lessee accounting: almost everything is on the balance sheet now
Under ASC 842, lessees recognize a right-of-use (ROU) asset and a lease liability for virtually all leases longer than 12 months — the old "operating lease = off-balance-sheet" treatment is gone. What survives from the old model is the income statement distinction between finance and operating leases.
Classification: finance vs. operating (lessee)
A lease is a finance lease if any one of these five criteria is met (otherwise it's operating):
- Ownership transfers to the lessee by the end of the lease term
- The lease contains a purchase option the lessee is reasonably certain to exercise
- The lease term is for the major part of the remaining economic life of the asset
- The present value of lease payments equals or exceeds substantially all of the asset's fair value
- The asset is so specialized it has no alternative use to the lessor at the end of the term
IMPORTANT: Both finance and operating leases put a ROU asset and lease liability on the balance sheet, measured identically at commencement (PV of lease payments). The difference is in subsequent measurement and expense pattern.
Subsequent accounting
| Finance lease | Operating lease | |
|---|---|---|
| Interest expense | Separate, effective-interest on liability | Combined into single lease expense |
| ROU amortization | Separate, typically straight-line | Combined into single lease expense |
| Expense pattern | Front-loaded (higher total expense early) | Straight-line (constant total expense) |
EXAMPLE: For an operating lease, total lease expense is recognized on a straight-line basis over the lease term, even if cash payments escalate — the ROU asset amortization is simply the difference between the straight-line expense and the interest accretion on the liability each period.
EXAM TIP: Short-term leases (12 months or less, no purchase option reasonably certain to be exercised) are exempt — lessees can elect to keep them off the balance sheet and expense payments straight-line, similar to old operating-lease treatment.