Leases – What You Need to Know About the Changes Part 3: Finance Lease Accounting
By Benjamin R. Ripple, CPA, Partner
In our last article, we covered accounting for operating leases by lessees (tenants) under the new standard. In this article, we will look at accounting for the alternative: the finance lease. Under the new lease standard, the finance lease essentially takes the place of the old capital leases in a lot of ways, and if you think about it in that light, it might make this accounting process easier.
In this article, we will cover step by step the basics for accounting for a finance lease under the new standard.
The first step in accounting for either an operating or finance lease is determining the amount to capitalize as the right-of-use asset and lease liability. This amount should be the present value of the expected lease payments. The expected lease payments should include payments to be made in optional periods if those periods are reasonably certain to be exercised. The expected lease payments should exclude most variable payments other than those that depend on an index or a rate. The discount rate used to determine present value of these payments should be the implicit rate of the lease, unless that rate cannot be easily determined. If that is the case, the discount rate should be the lessee’s incremental borrowing rate. This step is usually the most difficult part of the new lease standard, as there is a fair amount of judgment going into whether or not options will be renewed and what rate should be used to discount to present value.
If the preceding paragraph seems familiar, it should; I copied it almost verbatim from Part 2 of this series. The point in repetition is that first step is exactly the same under either type of lease, including the same judgments that are needed for determining discount rates and the intent to exercise options. After this initial step up, we get into where the two types of leases diverge from one another.
In operating leases, the lease liability and right-of-use asset generally equal each other. In a finance lease, the lease liability is reduced by payments net of interest incurred on the lease. Interest incurred on the lease should be based on the discount rate used in establishing the liability. The right-of-use asset should be amortized using the straight-line method. Like the old capital leases, this will result in your actual expense on the income statement being higher in the early years of a lease as more of the cash payment will be applied to interest than in later years.
Also in an operating lease, all of the expense goes to the same account on the income statement. In a finance lease, the amortization is recognized separately from the interest expense.
Finally, for cash flow purposes all operating lease activity is reported in the operating section of the cash flow statement. For finance leases, the payment of the principal portion of the lease liability is recognized in the financing activities, and all other activity is recognized in the operating activities section.
The difference between an operating and finance lease are fairly consistent with the differences that currently exist between an operating and capital lease. So, if you are comfortable with those differences, you should be okay with the differences after adopting the new standard. To make sure you have a good grasp on the differences, we will go through some examples in Part 4 of this series to illustrate how the same circumstances would look different under the two types of leases.
If you have any questions or concerns surrounding the new lease standard, please reach out to your trusted accounting advisors sooner rather than later.
Benjamin R. Ripple Partner, Assurance Practice Leader, CPA
Ben is a partner in BRC’s assurance services. Since starting his career in 2001, Ben has worked with clients ranging from family-owned companies, to multinational corporations, to not-for-profit and governmental entities requiring A-133 audits. Ben’s industry experience includes: Manufacturing and distribution Hospitality, including restaurants and hotels Investment companies Governmental and not-for-profit entities Affordable housing […]