FAR Lease Accounting: Guide to ASC 842 for the CPA Exam

Master FAR lease accounting under ASC 842. Learn lessee and lessor rules, ROU assets, lease liabilities, and key calculations for the CPA Exam.

Introduction to ASC 842 and the CPA Exam

Lease accounting is one of the most critical topics tested on the Financial Accounting and Reporting (FAR) section of the CPA Exam. Under the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 842, the rules for lease accounting changed significantly. The standard brought most leases onto the balance sheet for lessees. This change eliminated off-balance-sheet financing for operating leases.

Candidates preparing for the exam must understand how these rules apply to both lessees and lessors. The FAR section of the CPA Exam tests candidates on the classification, initial measurement, and subsequent measurement of leases for both lessees and lessors. To succeed on this part of the exam, you must master the underlying concepts and perform precise calculations. Reviewing the CPA exam sections can help you understand where lease accounting fits within your overall study plan.

Lessee Accounting: ROU Assets and Lease Liabilities

Under ASC 842, lessees are required to recognize a right-of-use (ROU) asset and a lease liability on the balance sheet for both operating and finance leases, unless the lease term is 12 months or less. This is a major departure from legacy GAAP, where operating leases only required footnote disclosures and periodic rent expense recognition. The ROU asset represents the lessee's right to use the underlying asset for the lease term. The lease liability represents the obligation to make lease payments.

For short-term leases with a term of 12 months or less, lessees can make an accounting policy election. This election allows them to keep the lease off the balance sheet. Instead, they recognize lease payments as an expense over the lease term on a straight-line basis. If you want to plan your study schedule to cover these balance sheet concepts, you can use the CPA study planner to allocate your time effectively.

The Five Criteria for Finance Lease Classification

Lessees must classify a lease as a finance lease if any of the five criteria are met at the commencement date. If none of these criteria are met, the lessee classifies the transaction as an operating lease. These criteria help determine whether the lease transfers control of the underlying asset to the lessee.

The first criterion is the transfer of ownership of the underlying asset to the lessee by the end of the lease term. The second criterion is the existence of a purchase option that the lessee is reasonably certain to exercise. The third criterion is a lease term that covers the major part of the asset's economic life. The fourth criterion is whether the present value of the sum of lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset. The fifth criterion is whether the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

To ensure you understand how these criteria are tested, you should review the official CPA exam blueprints. The blueprints outline the exact tasks you must perform on the exam, including classifying leases based on these five criteria.

Initial Measurement of Leases

CPA Exam candidates must be prepared to calculate the present value of lease payments using the rate implicit in the lease or the lessee's incremental borrowing rate to determine the initial lease liability. The rate implicit in the lease is the preferred rate. However, if that rate is not readily determinable, the lessee must use its incremental borrowing rate.

The lease payments included in the present value calculation consist of fixed payments, variable lease payments that depend on an index or rate, and the exercise price of a purchase option if the lessee is reasonably certain to exercise it. It also includes penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate. Once the lease liability is calculated, the initial ROU asset is determined. The ROU asset equals the initial lease liability plus any lease payments made to the lessor at or before the commencement date, plus any initial direct costs incurred by the lessee, minus any lease incentives received.

Subsequent Measurement and Expense Recognition

The subsequent measurement of a lease depends on its classification. For finance leases, the lessee amortizes the ROU asset on a straight-line basis over the shorter of the lease term or the useful life of the asset. The lessee also recognizes interest expense on the lease liability using the effective interest method. This results in a front-loaded expense profile, where total lease expense is higher in the early years of the lease.

For operating leases, lessees recognize a single lease cost allocated over the lease term on a straight-line basis, combining interest expense on the liability and amortization of the ROU asset. The single lease cost is recognized as a single line item on the income statement. The amortization of the ROU asset is calculated as the difference between the straight-line lease cost and the interest expense on the lease liability for that period. This ensures that the total periodic lease cost remains constant throughout the lease term.

Lessor Accounting Under ASC 842

Lessors classify leases under ASC 842 as sales-type leases, direct financing leases, or operating leases based on criteria related to control transfer and risks/rewards of ownership. If the lease transfers control of the underlying asset to the lessee, the lessor classifies it as a sales-type lease. This classification typically aligns with the lessee classifying the lease as a finance lease.

If control is not transferred but the lessor meets certain criteria regarding the collection of lease payments and residual value guarantees, the lease is classified as a direct financing lease. If the lease does not meet the criteria for either a sales-type or a direct financing lease, the lessor classifies it as an operating lease. For operating leases, the lessor keeps the underlying asset on its balance sheet and recognizes lease income on a straight-line basis over the lease term.

Exam Preparation and Study Strategies

To master far lease accounting, candidates must practice multiple-choice questions and task-based simulations. Focus on calculating the present value of lease payments and creating amortization schedules. Understanding the journal entries for both operating and finance leases is essential for success on the exam.

You can test your knowledge by taking a free CPA practice test. Practicing realistic questions will help you identify areas where you need more study. For additional tips on how to structure your study sessions, read our guide on CPA study tips. If you need more practice materials, check out our CPA practice questions to reinforce your understanding of ASC 842.

Frequently asked questions

What is the main difference between operating and finance leases for lessees under ASC 842?

Under ASC 842, both operating and finance leases require the lessee to recognize an ROU asset and a lease liability on the balance sheet. The main difference lies in expense recognition. Finance leases recognize interest expense and amortization expense separately, resulting in a front-loaded expense profile. Operating leases recognize a single lease cost on a straight-line basis over the lease term.

When can a lessee choose not to recognize a lease on the balance sheet?

A lessee can elect not to recognize an ROU asset and lease liability for short-term leases. A short-term lease is defined as a lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

How does a lessee determine the discount rate for a lease?

The lessee should use the rate implicit in the lease if it is readily determinable. If the implicit rate cannot be readily determined, the lessee must use its incremental borrowing rate. Nonpublic entities are also permitted to make an accounting policy election to use a risk-free rate.

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