Finance leases and operating leases are two common types of lease arrangements that businesses encounter. With the introduction of the ASC 842 accounting standard, the classification and treatment of leases have evolved. In this blog post, we will delve into the distinctions between finance leases and operating leases and discuss how ASC 842 impacts the accounting for these lease types.

Understanding finance leases and operating leases.

Under the previous ASC 840 standard, capital leases were categorized as financing arrangements and were recorded on the balance sheet, while operating leases were treated as a right to use the asset and remained off-balance sheet. However, this off-balance sheet accounting approach led to concerns, prompting the transition to the ASC 842 standard.

How does ASC 842 impact lease classification?

ASC 842 mandates that both finance leases and operating leases be recognized on the balance sheet. This change ensures greater transparency in lease accounting.

• In ASC 842, finance leases are now considered right-of-use assets, categorized as intangible assets. Instead of being expensed, these assets are amortized over their useful life. Finance leases also entail the recognition of separate interest expenses, which decline over time as the lease liability decreases.
• Similar to finance leases, operating leases under ASC 842 involve the recognition of right-of-use assets as intangible assets. However, the key distinction lies in expense recognition. Operating leases are expensed using a straight-line method, where lease payments are evenly distributed over the lease term. This results in a consistent lease expense throughout the lease duration.

What is the Expense Profile for Operating vs. Finance Leases?

The expense profile for finance leases differs from that of operating leases. Finance leases have higher expenses in the initial months and progressively decrease as the lease term progresses. On the other hand, operating leases maintain a constant expense level throughout the lease duration.

Understanding the differences between finance leases and operating leases is essential for businesses navigating lease accounting under ASC 842. With both types of leases now recognized on the balance sheet, organizations can provide more transparent financial reporting. By grasping the nuances of these lease classifications and their respective expense profiles, businesses can comply with accounting standards and make informed decisions regarding lease arrangements.