As accountants, we know that it’s one thing to learn everything about lease accounting when studying for your exams and quite another to account for leases in the real world. That’s because lease accounting adheres to specific standards that guide how leases should be classified.
But we've got your back with this refresher on everything you need to know about operating and finance leases. We’ll cover the typical journal entries used for an operating lease and a finance lease under ASC 842 and the financial statement impact of those journal entries, following along with a free download to help you with both types of leases.
Let’s start with an overview of the high-level differences between the two lease classifications to help you determine when to classify a lease as operating vs. finance.
Operating leases
An operating lease involves a contract that allows the lessee the right to use an asset, but the ownership of the asset remains with the lessor. After the lease term, the asset is returned to the lessor.
- Ownership/purchase option: The lessor owns the asset for the entire lease period. The lessee either doesn’t have a purchase option to buy the asset during the lease period or the option isn’t reasonably certain to be exercised.
- Lease term: The term of the lease typically extends to less than 75% of the projected useful life of the asset.
- Accounting under ASC 842: A single lease expense is recorded on a straight-line basis, and a lease liability is brought down using the effective interest method. This requires a “plug” of your monthly ROU asset draw-down.
- Examples: Operating leases include assets like office buildings and equipment such as laptops, printers, and projectors.
Finance leases
A finance lease (previously known as a capital lease) gives a lessee the right to use an asset, and the risks and rewards related to ownership of the asset are transferred to the lessee.
There are many criteria that go into determining if a lease should be classified as a finance lease. Below are a few examples of criteria that, if met, would classify it as a finance lease. You can also use our free Excel template to determine the right lease classification.
- Ownership/purchase option: Ownership of the asset transfers to the lessee by the end of the lease term or there is a purchase option that the lessee is reasonably certain to exercise. (There are exceptions to this criterion. For example, if it is a specialized asset, it can still be classified as a finance leave even if there is no purchase option or transfer of the asset.)
- Lease term: The term of the lease is for a major part of the remaining economic life of the asset. While there’s not a set threshold for this indicator, you can think of it as 75% or more of the asset’s remaining economic life. (This doesn’t apply to leases of land, as land has indefinite life.)
- Accounting under ASC 842: Depreciation and interest are recorded and are not included in earnings before interest, taxes, depreciation, and amortization (EBITDA).
- Examples: Finance leases include assets like specialized machinery and vehicles.
Operating and finance lease journal entry examples
Let’s go through some examples of operating and finance lease journal entries. To follow along, first download our free Excel template.
In the downloadable file and below, we will go through:
- How to evaluate if a lease should be classified as an operating or financing lease. (See Procedure #1 in the downloadable file, which includes a formula-driven tool to help you determine a lease classification.)
- An amortization schedule that can be used for both an operating and financing lease. (See Procedure #2 in the downloadable file.)
- The journal entries that you would book for each classification. (See Procedure #3 in the downloadable file.)
- The income statement and balance sheet impact of each classification. (See below and Procedure #3 of the downloadable file.)
Lease amortization schedule for operating and financing leases
Under each lease classification, an amortization schedule will be required to easily capture the lessee journal entries for each month of the lease term. One amortization schedule can be used to extract the necessary information for both operating and finance journal entries.
See Procedure #2 in the downloadable file for an example amortization schedule. The amortization schedule and examples through the remainder of this article are based on the following lease details:
- Commencement date: 1/1/2022
- Lease term (months): 60
- Final month: 12/1/2026
- Incremental borrowing rate: 7.50%
- Monthly payment (first year): $5,000
- Payment annual uplift percentage: 5%
Journal entries for operating and financing leases
The initial journal entries for both operating and finance leases will be the same:
- Credit lease liability: Present value of all future lease payments. The discount rate used in the calculation for this template is the incremental borrowing rate (IBR). You could also use the rate implicit in the lease, incremental borrowing rate, or risk-free rate.
- Debit right of use (ROU) asset: Equals your lease liability unless prepayments, initial direct costs, or lease incentives exist.
The monthly journal entries are the following for each classification:
For the operating lease:
- Debit lease expense: Straight-line computation of all future lease payments. Computed as the sum of future lease payment divided by the lease term.
- Debit lease liability: Reduces lease liability. Computed as the lease payment minus the interest accretion for the period on the lease liability balance.
- Credit ROU asset accumulated amortization: Reduces ROU asset. Computed as the subsidiary ledger (S/L) lease expense minus the interest accretion on the lease liability balance for the period.
- Credit lease payable (or cash): Represents the lease payment required for the period.
For the finance lease:
- Debit ROU amortization expense: S/L amortization over the term of the lease. Computed as initial ROU asset balance divided by the ROU asset useful life (which typically equals the term of the lease).
- Credit ROU accumulated amortization: Equals your ROU amortization expense for the period.
- Debit lease liability: Decreases lease liability. Computed as the lease payment minus the interest expense on the lease liability balance for the period.
- Debit interest expense: Interest for the period on the running lease liability balance.
- Credit lease payable (or cash): Represents the lease payment required for the period.
Income statement impact of operating and financing leases
Here’s what the income statement looks like for these leases:
For the operating lease:
- Lease expense is recorded within EBITDA.
- Lease expense will be consistent over the lease term.
For the financing lease:
- Interest and amortization are not recorded within EBITDA.
- The sum of the interest and amortization expense will be front-loaded, meaning the total expense will be larger early in the lease and lower toward the end, due to the nature of each period’s expense calculations.
The overall impact on the income statement:
- EBITDA is larger with a finance lease.
- Because of the front-loaded expense with a finance lease, operating leases present a larger net income early in the lease term relative to a finance lease and then a lower net income relative to a finance lease later in the lease term.
The largest difference between the lease classifications is where the expense hits the income statement, especially the impact on EBITDA. If EBITDA is an important metric at your company, then you might want to consider structuring your lease agreements to be primarily finance-type leases.
Balance sheet impact of operating and financing leases
Here’s what the balance sheet looks like for these leases:
The net ROU asset on the balance sheet is larger early in the lease term with an operating lease. The opposite is true later in the lease term. This is because the finance lease S/L amortizes the ROU asset through the lease term, while the operating lease amortizes by taking the lease expense less the interest accretion for the period.
The interest accretion is greater early in the lease term because of a larger lease liability balance early on, thereby making the amortization smaller early in the lease term for an operating lease.
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Operating and finance lease FAQs
How do you record an operating lease?
Under accounting standards such as IFRS and US GAAP, operating leases are recorded differently from finance leases. When a company enters an operating lease agreement, the expense is recognized on a straight-line basis over the lease term, which means that the total lease payments are spread out evenly over the lease term. This is calculated by dividing the sum of all lease payments by the number of periods in the lease term. The asset and liability are recorded on the balance sheet.
Where should I record an operating lease?
If you are a lessee, you should record an operating lease on your company's balance sheet as a ROU asset and a lease liability.
The ROU asset represents the lessee's right to use the leased asset, and it should be recorded at the present value of the lease payments over the lease term, adjusted by initial direct costs, lease prepayments, or lease incentives.
The lease liability represents the lessee's obligation to make lease payments over the lease term, and it should also be recorded at the present value of the lease payments.
Do you record interest on an operating lease?
No, interest is not recorded on an operating lease. When a lease is classified as operating, such as when no ownership transfer occurs at the end of the lease term, interest expense is not separately recognized and is instead incorporated into period rent expense.
Do operating leases have ROU assets?
Yes, operating leases have ROU assets. In fact, ASC 842 requires that operating leases be recognized on a company's balance sheet as ROU assets and corresponding lease liabilities. Prior to the adoption of ASC 842, operating leases were typically disclosed only in the footnotes of a company's financial statements.
However, under the current standard, companies are required to recognize these leases as assets and liabilities, which may significantly impact their financial position and key financial ratios.
