accounting made sense

Journal Entries for Finance Lease: ASC 842 – Simple Guide

Journal Entries for Finance Lease ASC 842 - Simple Guide

Table of Contents

While ASC 842 and finance lease can be complex, and numerous online guides already explain it, a simple example can often clarify its nuances. That’s what this article is here for. We’ll provide an example of simplified finance lease journal entries covering the perspective of the property renter (lessee).

Related reading:

ASC 842 Journal Entries – Operating Lease (Lessee and Lessor)

ASC 842 Journal Entries – Sales-type Lease (Lessor)

ASC 842 Journal Entries – Direct Financing Lease (Lessor)

Month-To-Month Lease Under ASC 842

Quick Recap – Finance Lease under ASC 842:

  • Balance Sheet Treatment: Lessees recognize a right-of-use (ROU) asset and a corresponding lease liability to reflect the lease payment obligation.
  • Expense/P&L Recognition: Lessees recognize two components: 1) Depreciation expense from the ROU asset, which is treated on a straight-line basis. 2) Interest expenses from the lease liability.
  • Characteristics (any of the following):
    • The lessor might transfer ownership of the asset to the lessee by the end of the lease term.
    • The lessee has the option to purchase the asset at the end of the lease and is expected to exercise that option.
    • The lease term takes up most of the economic life of the underlying asset. 75% is the threshold. (The lease will cover 75% or more of the economic life of the asset.)
    • The present value of the sum of lease payments is substantially all of the asset’s overall fair value. 90% is the cutoff. (The PV of payment is at 90% or more of the asset’s fair value.)
    • The asset is specifically customized or specialized for the lessee’s use. In other words, the asset can’t be directly used by anyone else after it is returned to the lessor.
  • Classification of Finance lease: If a lease satisfies any of the above characteristics, it is classified as a finance lease. Otherwise, it’s an operating lease.

Finance Lease vs. Operating Lease

  • As mentioned above, a finance lease possesses at least one of the following characteristics. If the lease does not meet any of these conditions, then it’s classified as an operating lease.
    • Ownership transfer at the end of the lease
    • The option exists for the lessee to purchase the asset at the end of the lease.
    • “75%” economic life threshold
    • “90%” present value of payment threshold
    • Customized asset for lessee’s use
  • For finance leases, the primary cost or P&L effect is the depreciation expense of the ROU asset, along with the interest expense from the payment obligation. On the other hand, the P&L impact for operating leases is limited to the rent cost.
  • Cost is front-loaded for finance leases because of the interest expense. In comparison, operating leases are treated on a straight-line basis; therefore, the cost is spread out.

Short-term Lease Exemption: ASC 842 provides an optional exemption for leases with a term of 12 months or less. If a lessee elects this exemption, then the lessee would not recognize an ROU asset or lease liability, and lease payments would be expensed when paid. See here for more details.

Related reading:

Is Right-of-use (ROU) Asset a Fixed Asset?

What Is a Lease Accountant and What Do They Do?

Example: Journal Entries for Finance Lease – Lessee

Scenario:

  • Pho My Life (PML) Noodles Shop has decided to lease an oven 
  • Length: 3 years
  • Yearly lease payment of $10,000. $30,000 in total for three years.
  • Interest rate: 10%

Year 0 (Beginning of the lease)

Important: Before recording journal entries, we have to compute the present value of the sum of the lease payments. This can be done via a calculator:

PV of sum of lease payment calculator

From the calculations, the present value of the annual payments, with each year being $10,000 at a 10% interest rate for three years, is $24,868.50. Once we have determined the PV, we record the following entry.

Initial recognition journal entry - finance lease

  • We record a ROU asset of $24,868.50 on the balance sheet as it’s a resource that will benefit the PML noodle shop. (See here for a definition of asset.)
  • On the other hand, we record a liability of $24,868.50, representing the payment obligation of this lease.

Year 1

Interest Expense Calculation: 10% of $24,868.50 (Lease Liability at the beginning) = $2,486.85

Principal or liability Reduction: Total Payment ($10,000) – Interest Expense ($2,486.85) = $7,513.15

Remaining Lease Liability = $24,868.50 – $7,513.15 = $17,355.35

Depreciation expense: $24,868.50/3 = $8,289.50

Year 1 interest expense and lease payment journal entry - finance lease

The lease payment of $10,000 will include 

  • interest expenses of $2,486.85 (as a debit)
  • Reduction to liability of $7,513.15 (as a debit)
  • Payment of $10,000 is just a credit to cash

Year 1 ROU asset depreciation - finance lease

The ROU asset is depreciated on a straight-line basis for 3 years. Therefore, it’s a debit to depreciation expense for $8,289.50 and a credit to accumulated depreciation for the same amount.

Year 2

Interest Expense Calculation: 10% of $17,355.35 (remaining lease liability) = $1,735.54

Principal or liability Reduction: Total Payment ($10,000) – Interest Expense ($1,735.54) = $8,264.46

Remaining Lease Liability = $17,355.35 – $8,264.46 = $9,090.89

Depreciation expense: $24,868.50/3 = $8,289.50

Year 2 Journal Entry - Finance Lease

The lease payment of $10,000 will include 

  • interest expenses of $1,735.54 (as a debit)
  • Reduction to liability of $8,264.46 (as a debit)
  • Payment of $10,000 is a credit to cash

For ROU asset depreciation, it’s the same amount each year for $8,289.50

Year 3

Interest Expense Calculation: 10% of $9090.89 (remaining lease liability) = $909.09

Principal or liability Reduction: Total Payment ($10,000) – Interest Expense ($909.09) = $9,090.91

Remaining Lease Liability = $9,090.89 – $9,090.91 = $0 (ignoring immaterial rounding difference)

Depreciation expense: $24,868.50/3 = $8,289.50

Year 3 Journal Entry - Finance Lease

The lease payment of $10,000 will include 

  • interest expenses of $909.09 (as a debit)
  • Reduction to liability of $9,090.91 (as a debit)
  • Payment of $10,000 is a credit to cash

For ROU asset depreciation, it’s the same amount each year for $8,289.50.

This is the last year of the lease term, and the ROU asset will be fully depreciated by the end of the year. The corresponding lease liability will be fully settled as well. 

Here is a summary:

ASC 842 Finance Lease Journal Entries - a simple example

Key Takeaways

  • The ROU asset and liability are initially recognized for the “principal” only. (As the payment each year only reduces the principal while the interest component is expensed separately.)
  • As a result, at the end of year 3, the ROU asset and the liability will be fully settled and zeroed out.
  • On the P&L side, each year, there will be two impacts 1) depreciation expense from the ROU asset and 2) Interest expense.
  • Comparison to operating lease journal entries
    • Operating leases lead to a single, straight-line lease expense, whereas finance leases result in a split between interest expense and amortization expense.
    • Because the interest expense is tilted heavily towards the earlier year of the lease term, the finance lease cost is more front-loaded than the operating lease, which is evenly spread out.

Leave a Reply

Your email address will not be published. Required fields are marked *

Table of Contents