Navigating Finance Leases and Operating Leases in U.S. GAAP for the FAR CPA Exam

Introduction

One of the most nuanced topics in accounting under U.S. Generally Accepted Accounting

Principles (U.S. GAAP) is lease accounting. Leases are broadly classified into two types: finance leases and operating leases. Both come with specific accounting treatments that candidates preparing for the Financial Accounting and Reporting (FAR) CPA exam need to grasp. Let’s delve into the accounting intricacies surrounding these leases.

Definitions

Finance Lease

A finance lease transfers substantially all the risks and rewards of asset ownership to the lessee. Essentially, it’s akin to a purchase by the lessee.

Operating Lease

In an operating lease, the lessor retains the risks and rewards of ownership. The lessee merely uses the asset during the lease term.

Recognition Criteria

Finance Lease

For a lease to be classified as a finance lease under U.S. GAAP, any one of the following criteria must be met:

1. Ownership transfer to the lessee by the end of the lease term.

2. Option to purchase the asset at a bargain price.

3. Lease term covering a major part of the asset’s economic life.

4. Present value of lease payments comprising a substantial portion of the asset’s fair value.

5. The asset is specialized, and only the lessee can use it without substantial modification.

Operating Lease

If none of the above criteria are met, the lease is generally classified as an operating lease.

Journal Entries for Finance Lease

Example 1: Initial Recognition

Suppose a company enters into a finance lease for equipment worth $50,000, to be paid in 5

yearly installments of $11,000.

• Debit Equipment (Asset) $50,000

• Credit Lease Liability $50,000

Example 2: Lease Payment

Upon making the first annual payment of $11,000:

• Debit Interest Expense (approx) $5,000

• Debit Lease Liability $6,000

• Credit Cash $11,000

Journal Entries for Operating Lease

Example 3: Lease Payment

If the same company instead enters an operating lease with a yearly payment of $10,000:

• Debit Rent Expense $10,000

• Credit Cash $10,000

Balance Sheet Presentation

Finance leases lead to both an asset and a liability on the balance sheet. Operating leases,

under U.S. GAAP, are generally not recognized on the balance sheet, though disclosures are needed.

Disclosures

Companies must provide detailed disclosures about their lease transactions, which include

nature, terms, and payments due in future periods, among other details.