Operating lease vs finance lease
Each, defined
Operating lease
Operating lease — Under ASC 842, a lessee lease that is not a finance lease — on the balance sheet, with a single straight-line lease cost in the P&L.
Finance lease
Finance lease — A lease that effectively transfers control of the asset — ownership transfer, purchase option reasonably certain, major part of life or substantially all of fair value, or a specialized asset — expensed as amortization plus interest.
Side by side
| Operating lease | Finance lease | |
|---|---|---|
| Right-of-use asset and liability | Yes | Yes |
| P&L presentation | One straight-line lease cost | Interest plus amortization |
| Expense pattern | Level | Front-loaded |
| Cash flow statement: payments | Operating | Principal in financing, interest per policy |
The same lease, booked both ways
A 36-month lease at $10,000 a month in advance, discounted at 7%. Booked as an operating lease the P&L carries the same cost every year; as a finance lease the first year carries more and the last year less. Over the lease both expense $360,000, to the cent.
| Lease year | Operating lease cost | Finance: interest | Finance: amortization | Finance: total |
|---|---|---|---|---|
| Year 1 | 120,000.00 | 18,900.03 | 108,584.52 | 127,484.55 |
| Year 2 | 120,000.00 | 11,591.50 | 108,584.52 | 120,176.02 |
| Year 3 | 120,000.00 | 3,754.62 | 108,584.81 | 112,339.43 |
How they relate
ASC 842 ended off-balance-sheet leases: both kinds now carry the right-of-use asset and the liability. The classification decides only how the cost reaches the income statement.
Because a finance lease's interest falls as the liability is paid down, its total expense is highest in year one. That matters to EBITDA, which excludes interest and amortization but includes operating lease cost.
Questions
- What makes a lease a finance lease?
- If the lease transfers ownership, includes a purchase option the lessee is reasonably certain to use, runs for the major part of the asset's life, has payments worth substantially all of its fair value, or covers an asset so specialized it has no alternative use to the lessor.
- Is there a short-term exemption?
- Yes. A lessee may elect not to recognize leases of twelve months or less with no purchase option it is reasonably certain to exercise.
See it computed
Worked through: the calculators, the journal entries and the tools that use these terms.
- Journal entry for an operating lease under ASC 842At commencement, debit Right-of-use asset and credit Lease liability for the present value of the payments. Each payment debits Lease liability and credits Cash; each month-end debits Operating lease cost for the straight-line cost and credits Lease liability for the interest and the right-of-use asset for the rest.Entry
- Journal entry for a finance lease under ASC 842At commencement, debit Right-of-use asset and credit Lease liability for the present value of the payments. Each payment debits Lease liability and credits Cash; each month-end debits Interest expense and credits Lease liability for the interest, and debits Amortization expense and credits the right-of-use asset for straight-line amortization.Entry
- Lease — ASC 842 / IFRS 16PV of the payments at your IBR, the liability unwind and the ROU asset — straight-line for a finance lease, the plug to a level cost for an operating one.Tool
Definitions are the glossary’s, generated from the same documents. Figures in the examples are computed by tested functions, not typed. General information for US companies under US GAAP, not accounting or tax advice.