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Journal Entries for Operating Lease: ASC 842 – Simple Guide

Journal Entries for Operating Lease ASC 842 - a Simple Guide

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ASC 842 can be overwhelming; we often just need a quick journal entry example to understand the concept or refresh our memory. This article serves just that purpose. Here, we’ll break down operating lease journal entries simply and straightforwardly, including both the lessee and lessor sides.

Related reading:

ASC 842 Journal Entries – Finance Lease (Lessee)

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 – Operating Lease under ASC 842:

  • Balance Sheet Treatment: Lessees recognize a right-of-use (ROU) asset and a corresponding lease liability for the lease payment obligation.
  • Expense Recognition: Lessees typically recognize lease expenses on a straight-line basis over the lease term.
  • Characteristics:
    • No owner transfer or bargain price purchase at the end of the lease.
    • The lease term is shorter than the economic life of the underlying asset. (“75%” rule)
    • The present value of the sum of lease payments is less than the asset’s overall fair value. (“90%” rule)
    • The asset is not customized and can be used by anyone, not just the lessee.
  • Classification of Operating Lease: If a lease satisfies ALL of the above characteristics, it is classified as an operating lease. Otherwise, it’s a finance lease.

Operating Lease vs. Finance Lease

  • Ownership is often transferred, or there is a bargain price purchase option at the end of finance leases. Operating leases don’t have those options.
  • A finance lease often takes up the majority of the economic life of the underlying asset. In addition, the present value of lease payment is often the majority of the asset’s overall fair value. Operating leases do not meet any of these conditions.
  • A finance lease may have the underlying asset customized exclusively for the lessee’s use. On the other hand, an operating lease does not customize the asset; the assumption is it can be used by anyone else.
  • The P&L impact of the finance lease is recorded as depreciation in addition to interest expense, whereas the impact of the operating lease is classified as an operating expense or rent.
  • The P&L impact for the finance lease is front-loaded with the recognition of interest, while the operating lease is on a straight line.

Short-term Lease Exemption: Under ASC 842, there’s an exemption for leases that last 12 months or less. Instead of recording the lease as an asset or liability, the lessee can simply expense the lease payments as they are made. 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 Operating Lease – Lessee

Scenario

  • Pho My Life (PML) Noodles Shop decided to lease an oven 
  • Length: 3 years
  • Yearly lease payment of $10,000
  • Interest rate: 5%

Year 0 (Beginning of the lease):

The first step is to calculate the present value (PV) of the lease payments to determine the lease liability. 

Year 1: $10,000 ÷ (1.05)^1 = $9,523.81 

Year 2: $10,000 ÷ (1.05)^2 = $9,070.29 

Year 3: $10,000 ÷ (1.05)^3 = $8,638.38

Total Present Value = $27,232.48

You can also use the PV of Payment calculator instead of manual calculation.

Once we determine the present value of the lease payment, we will record the following entry:

  • Right-of-use (ROU) asset account is debited for $27,232.48. Per ASC 842, an asset must be recognized because it is a resource that will benefit the PML Noodles Shop in the future.
  • A liability of $27,232.47 is recognized too. It represents the total payment obligation discounted by the interest rate of 5%

Year 1:

Interest Expense Calculation: 5% of $27,232.48 (Lease Liability at the beginning) = $1,361.62

Principal Reduction: Total Payment ($10,000) – Interest Expense ($1,361.62) = $8,638.38

  • On the debit side, the PML Noodles Shop needs to record the lease expense of $10,000, which includes Principal ($8,638.38) and Interest ($1,361.62)
  • On the credit side, they need to record the cash payment of $10,000

  • The PML Noodles Shop also needs to amortize the principal amount from the Right-of-use (ROU) asset and reduce the liability account – $8,638.38

Year 2:

The interest expense will be based on the new outstanding lease liability, which is now ($27,232.48 – $8,638.38) = $18,594.10.

Interest Expense Calculation: 5% of $18,594.10 = $929.71

Principal Reduction: Total Payment ($10,000) – Interest Expense ($929.71) = $9,070.29

  • Similar to year 1, the PML Noodles Shop records the cash payment and the operating lease expense of $10,000. This $10,000 includes $9,070.29 principal and $929.71 Interest
  • Similar to year 1, they also need to amortize the principal amount from the Right-of-use (ROU) asset and reduce the liability account – $9,070.29

Year 3:

The remaining lease liability in year 3 is ($18,594.10 – $9,070.29) = $9,523.81

Interest Expense Calculation: 5% of $9,523.81 = $476.19

Principal Reduction: Total Payment ($10,000) – Interest Expense ($476.19) = $9,523.81. 

  • Similar to year 1 and year 2, the PML Noodles Shop records the cash payment and the operating lease expense of $10,000. This $10,000 includes $9,523,81 principal and $476.20 Interest
  • By the end of Year 3, the ROU Asset and the Lease Liability will be fully amortized and paid off, respectively. Therefore, the amortization of $9,523.81 will wipe out the remaining ROU asset and liability balance.

Note: The above example simplifies the present value calculation. In a real-world scenario, calculating present value can be more complex based on the timing of payments and interest rate compounding intervals, such as those that involve prepaid rent. In addition, lease payments will often grow in a multi-year lease, which means the payment amount sometimes varies from the lease expense recognized in each period.

However, the example above shows how basic operating lease journal entries are recorded; ROU asset and lease liability are amortized for the principal amount only, while the actual lease expense includes both interest and the principal component.

Example: Journal Entries for Operating Lease – Lessor

Journal entries on the lessor’s side are much more straightforward. Assume the same facts as the example above:

  • Oven Rental (Lessor) is leasing out an oven to Pho My Life Noodles Shop (Lessee)
  • Length: 3 years
  • Yearly lease payment receivable of $10,000

Beginning of Lease: No initial financial transaction happens. The oven, being an asset, remains on the lessor’s books.

Each Year of Lease: As Oven Rental (Lessor) receives the annual lease payment from Pho My Life Noodles Shop (Lessee)

  • Oven Rental can simply classify the $10,000 cash receipt as a lease income.
  • Each year, Oven Rental receives the same payment. Therefore, the journal entry is the same for all three years.

Since the oven remains an asset for Oven Rental, they would also record its depreciation. Let’s say the oven was worth $50,000 and had a 10-year life:

  • Oven Rental records the depreciation of this oven on its book using the straight-line method. $50,000 / 10 years = $5,000 per year
  • Oven Rental repeats the same journal each year during the 3-year lease term. In other words, the depreciation of assets is irrelevant to the lease terms.

Key Takeaways

Lessee

  • Right-of-use (ROU) assets and Lease liability are initially recorded as the Present Value (PV) of future lease payments.
  • Lease expense includes both the principal and interest amount. On the other hand, Right-of-use (ROU) assets and Lease liability are amortized/reduced for the principal amount only.
  • Lease expense is recognized as an operating expense as opposed to depreciation expense.

Lessor

  • Record lease/rental income when the lessee makes the lease payment
  • Record depreciation of the underlying asset as normal. It is irrelevant to the lease terms.

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