FAR Notes: Lease Accounting (ASC 842) for Lessees

Under old ASC 840, operating leases stayed off the balance sheet, hiding massive obligations from investors. ASC 842 ended that: the lessee now records a right-of-use (ROU) asset and a lease liability for almost every lease. These FAR lease accounting notes cover what the exam tests: classification, measurement, and the journal entries.

In this note:

• Finance vs operating: the 5 tests
• Initial measurement: liability first, asset second
• Subsequent measurement: where finance and operating split
• Worked example: these FAR lease accounting notes in action
• The short-term lease exemption
• Quick revision
• FAQ

Finance vs operating: the 5 tests

Classification is tested at lease commencement, and it uses a simple rule: if the lease meets ANY ONE of the five criteria below, it is a finance lease. Meet none, and it is an operating lease. (ASC 842-10-25-2)

1. Transfer of ownership. The lease transfers title to the lessee by the end of the term.
2. Purchase option. The lease includes a purchase option the lessee is reasonably certain to exercise.
3. Lease term. The lease term covers a major part of the asset’s remaining economic life. The old 75% bright line is gone as law, but many companies still use about 75% as a reasonable policy (ASC 842-10-55-2).
4. Present value. The present value of the lease payments (plus any residual value the lessee guarantees) equals or exceeds substantially all of the asset’s fair value. The old 90% benchmark survives the same way: as a common policy, not a rule.
5. Specialized asset. The asset is so specialized it has no alternative use to the lessor when the lease ends. Think custom-built factory equipment, not office space.

On the exam, meeting just one of these tests is enough to force finance classification, so a single clear trigger, such as a purchase option the lessee is reasonably certain to exercise, settles the question without checking the other four. When none of the five is met, the lease stays operating, but it still goes on the balance sheet.

Initial measurement: liability first, asset second

Always measure the liability first:

Lease liability = present value of the lease payments over the lease term, discounted at the rate implicit in the lease. If you cannot determine that rate (lessors rarely share it), use your own incremental borrowing rate. Private companies may use a risk-free rate instead.

ROU asset = lease liability + initial direct costs + any payments made before commencement minus lease incentives received. Start with the PV of what you owe, then adjust for anything already paid or received around the deal.

In short, first discount every payment you owe to get the liability, then build the ROU asset from that liability by adding upfront costs and prepayments and subtracting incentives. For the exam, get the discount rate order right: the implicit rate first, your incremental borrowing rate second, and the risk-free rate only for private companies.

Subsequent measurement: where finance and operating split

Finance lease: two separate expenses. Interest on the lease liability (effective interest method, so it is highest early and declines) plus straight-line amortization of the ROU asset. Total expense is front-loaded: bigger in year 1, smaller later. On the cash flow statement, the principal portion of payments is a financing outflow.

Operating lease: one single lease expense, recognized on a straight-line basis over the term. The liability still accretes interest and is reduced by payments behind the scenes, and the ROU amortization is simply the plug that keeps total expense flat. All cash payments are operating outflows.

Finance lease vs operating lease

	Finance lease	Operating lease
Expense pattern	Two expenses: interest on the liability plus ROU amortization; total expense is front-loaded	One single lease expense on a straight-line basis
Cash flow statement	Principal portion of payments is a financing outflow	All cash payments are operating outflows
Balance sheet	ROU asset and lease liability	ROU asset and lease liability
Total expense timing	Higher in early years, lower later	Flat in every period

This is the core of the dual model: both lease types sit on the balance sheet, but the income statement and the cash flow statement treat them differently, and that timing difference is exactly what exam questions test.

Worked example: these FAR lease accounting notes in action

A company signs a 3-year lease with annual payments of $10,000 at each year-end. No ownership transfer, no purchase option, the asset has a 10-year life, and the PV of payments is well under 90% of fair value. Classification: operating lease (none of the 5 tests met). The company’s incremental borrowing rate is 6%.

PV of payments = $10,000 x 2.6730 (PV annuity factor, 6%, 3 periods) = $26,730.

At commencement: Dr ROU Asset 26,730; Cr Lease Liability 26,730.

Year 1 as an operating lease: Single lease expense = $30,000 / 3 = $10,000. Interest on liability = $26,730 x 6% = $1,604. ROU amortization (the plug) = $10,000 minus $1,604 = $8,396. Dr Lease Expense 10,000; Cr Cash 10,000 (and the liability/asset roll forward behind the scenes).

Now compare: if this had been a finance lease, Year 1 would show interest of $1,604 plus ROU amortization of $8,910 ($26,730 / 3), for total expense of $10,514 versus $10,000 under operating treatment. Same lease, same cash, different P&L timing, and that timing difference is exactly what exam questions probe.

Walk through the logic once more: with a 3-year term against a 10-year life, the lease covers far less than a major part of the asset’s life, and a PV well under 90% of fair value fails the present value test, so with no transfer, no purchase option, and no specialized asset, operating treatment follows. Notice the commencement entry simply records the PV on both sides of the balance sheet; the finance versus operating difference only changes how expense hits the P&L afterward.

The short-term lease exemption

Leases with a term of 12 months or less (including renewal options you are reasonably certain to exercise) can skip ROU and liability recognition entirely. You elect this by class of underlying asset, and you simply recognize lease expense on a straight-line basis. Note there is no low-value exemption under US GAAP (unlike IFRS 16), so a cheap 5-year lease still goes on the balance sheet.

Exam trap: students see “operating lease” and write “off-balance-sheet” out of old habit. Under ASC 842, operating leases sit ON the balance sheet.

Exam trap: the purchase-option test asks whether exercise is reasonably certain, not whether the option merely exists.

Exam trap: only the lessee-guaranteed portion of a residual value goes into the PV calculation for test 4. An unguaranteed residual is the lessor’s problem, not yours.

The exemption is elected for a whole class of underlying asset at a time, not lease by lease, and a qualifying 12-month-or-less lease keeps things simple: no ROU asset, no lease liability, just straight-line expense.

Quick revision

FAQ

Does an operating lease affect EBITDA under ASC 842? No: the single straight-line expense sits above the EBITDA line, so EBITDA is unchanged. A finance lease splits into interest and amortization, both added back, so finance leases boost EBITDA. A classic exam comparison.

What happens if a lease is modified? You reassess: remeasure the liability, adjust the ROU asset, and potentially reclassify the lease.

Is IFRS 16 the same as ASC 842? Not for lessees. IFRS 16 uses a single model while ASC 842 keeps the dual finance/operating model with different P&L patterns. The CPA exam tests US GAAP, so learn the dual model cold.

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