Navigating Finance Leases and Operating Leases in U.S. GAAP for the FAR CPA Exam
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Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
Lease accounting is one of the more nuanced topics on the FAR section of the CPA exam. Under U.S. GAAP (ASC 842), leases are classified as either finance leases or operating leases, each with its own accounting treatment.
What is a finance lease?
A finance lease transfers substantially all the risks and rewards of ownership to the lessee — economically, it's similar to a purchase.
What is an operating lease?
In an operating lease, the lessor retains the risks and rewards of ownership. The lessee simply uses the asset for the lease term.
How is a lease classified as a finance lease?
Under ASC 842, a lease is classified as a finance lease if any one of these criteria is met:
- Ownership of the asset transfers to the lessee by the end of the lease term
- The lessee has an option to purchase the asset at a bargain price
- The lease term covers a major part of the asset's remaining economic life
- The present value of lease payments amounts to substantially all of the asset's fair value
- The asset is so specialized that only the lessee can use it without substantial modification
If none of these criteria are met, the lease is classified as an operating lease.
What are the journal entries for a finance lease?
Example: initial recognition. A company enters a finance lease for equipment worth $50,000, to be paid in 5 yearly installments of $11,000.
- Debit Right-of-Use Asset $50,000
- Credit Lease Liability $50,000
Example: the first annual payment. Of the $11,000 paid, part is interest and part reduces the liability:
- Debit Interest Expense $5,000
- Debit Lease Liability $6,000
- Credit Cash $11,000
What are the journal entries for an operating lease?
Under ASC 842, an operating lease also starts with a right-of-use asset and lease liability — measured the same way as a finance lease at commencement.
Example: initial recognition for a lease with a $10,000 annual payment:
- Debit Right-of-Use Asset (present value of payments)
- Credit Lease Liability (present value of payments)
Example: the annual lease expense. Unlike a finance lease, an operating lease recognizes a single, straight-line lease expense each period instead of splitting interest and amortization:
- Debit Lease Expense $10,000
- Credit Right-of-Use Asset / Lease Liability (net adjustment) $10,000
How do finance and operating leases show up on the balance sheet?
This is the most commonly missed point on the exam: both finance leases and operating leases put a right-of-use asset and a lease liability on the balance sheet under ASC 842. That wasn't always true — the old standard (ASC 840) kept operating leases off the balance sheet entirely, but ASC 842 closed that gap.
The real difference between the two lease types is how the expense is recognized over time:
- Finance lease — separate interest expense (front-loaded, declining as the liability shrinks) plus straight-line amortization of the right-of-use asset. Total expense is higher in earlier years.
- Operating lease — a single lease expense recognized on a straight-line basis for the entire term.
What must be disclosed?
Companies must provide detailed lease disclosures, including the nature of the lease arrangements, key terms, and future payments due in upcoming periods.
Both lease types are on the balance sheet under ASC 842 — the split is in how the expense is recognized. Finance leases front-load expense through separate interest and amortization; operating leases spread it evenly as a single straight-line expense.
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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 95 on FAR. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.
