How to understand lease accounting journal entries (for lessees)

Operating lease journal entries

Under ASC 842, an operating lease is accounted for as follows: 

Initial recognition of lease liability: The lessee should record a lease liability on their balance sheet, equal to the present value of the lease payments over the lease term. This amount should be discounted using the lessee’s incremental borrowing rate/Risk Free Rate (as applicable) or the interest rate implicit in the lease, if determinable. The lease liability will be further broken down into current and long-term liability portions and be credited when establishing the initial lease liability.

Initial recognition of right-of-use asset: The lessee should also record a right-of-use asset on their balance sheet, initially measured as the lease liability amount plus any initial direct costs incurred by the lessee minus any lease incentives. Right-of-use asset will be debited to establish the initial asset balance.

Subsequent measurement and amortization of lease liability: The lease liability shall be remeasured as necessary to reflect changes in the lease payments or lease term driven by lease lifecycle events such as modifications, extensions and certain kinds of payment adjustments. Each lease period will reclassify some portion of the long-term liability to the current liability resulting in a Debit to long-term liability and a credit to current liability. The liability is amortized over the reasonably certain lease term using the effective interest method.

Subsequent measurement and amortization of right-of-use asset: The right-of-use asset is measured initially at the lease liability amount, adjusted for any lease incentives received and initial direct costs incurred.  The right of use asset is amortized using a method that is unique to ASC 842. The total lease expense remains flat from period to period. This includes the imputed interest that tapers as the liability is paid down, while the difference between the straight-line lease expense and the imputed interest (aka the plug) represents the imputed depreciation, which is credited to accumulated depreciation account.

Recognition of lease expense: The lessee recognizes lease expense on a straight-line basis over the lease term. The lease expense is recognized in the income statement as a single line item that includes both the imputed interest expense on the lease liability and the imputed amortization expense on the right-of-use asset, as explained in the above paragraph. Variations in lease payments that are not known in advance are expensed as incurred. These may be both positive and negative. Related executory costs such as maintenance, utilities etc. are also recorded in the period incurred, as operating expenses.

For short term leases, the lease expense is leveled over the reasonably certain term and any timing difference between lease payment and expense is parked in a deferred rent account.

Finance lease journal entries

Under ASC 842, a finance lease is accounted for as follows: 

Initial recognition of lease liability: The lessee should record a lease liability on their balance sheet, equal to the present value of the lease payments over the lease term. This amount should be discounted using the lessee’s incremental borrowing rate/Risk Free Rate (as applicable) or the interest rate implicit in the lease, if determinable. The lease liability will be further broken down into current and long-term liability portions and be credited when establishing the initial lease liability.

Initial recognition of right-of-use asset: The lessee should also record a right-of-use asset on their balance sheet, initially measured as the lease liability amount plus any initial direct costs incurred by the lessee minus any lease incentives. The initial measurement of right-of-use asset will be debited to establish the initial measurement.

Subsequent measurement and amortization of lease liability: The lease liability shall be remeasured as necessary to reflect changes in the lease payments or lease term driven by lease lifecycle events such as modifications, extensions and certain kinds of payment adjustments. Each lease period will reclassify some portion of the long-term liability to the current liability resulting in a Debit to long-term liability and a credit to current liability. The liability is amortized over the reasonably certain lease term using the effective interest method.

Recognize interest expense and amortization expense: The lessee should recognize interest expense on the lease liability and amortization expense on the right-of-use asset over the lease term. The right-of-use asset needs to be amortized over the life of the lease (typically on a straight-line basis), except if the lease has a reasonably certain purchase option (RCPO) at the end of the lease term. If RCPO exists, the present value of the RCPO price is capitalized at lease commencement by debiting the right-of-use asset, and crediting liability for the expected purchase price. The Liability accretes interest over the term of the lease so that its credit balance equals the RCPO price at the end of the lease. The right-of-use asset (which includes the base asset and the PV of the RCPO price) is amortized over a term determined by the lessee’s depreciation policy for owned assets, depending on the asset class to which it belongs. Such amortization term is typically longer than the lease term.