How to Record a Lease in Accounting: Journal Entries

Recording a lease in accounting follows current accounting standards. The Financial Accounting Standards Board (FASB) introduced Accounting Standards Codification (ASC) 842, which significantly changed how organizations in the United States report their lease agreements. This standard aims to enhance transparency in financial reporting by requiring nearly all leases to be recognized on the balance sheet, providing a clearer picture of a company’s financial obligations.

Fundamental Lease Accounting Concepts

ASC 842 significantly changed lease accounting by bringing most leases onto the balance sheet. Under ASC 840, many operating leases were considered “off-balance sheet” financing, meaning the assets and liabilities associated with these leases were not formally recognized, which could obscure a company’s true financial leverage. ASC 842 addresses this by requiring lessees to recognize a Right-of-Use (ROU) asset and a corresponding lease liability for most leases, thereby increasing transparency and comparability across organizations.

A Right-of-Use (ROU) asset represents the lessee’s right to control the use of an identified asset for the lease term. The lease liability is the obligation to make lease payments arising from the lease, measured on a discounted basis.

The lease term is the noncancellable period a lessee has the right to use an underlying asset, including periods with reasonably certain extension or termination options. The discount rate calculates the present value of lease payments. The rate implicit in the lease is preferred; otherwise, the lessee’s incremental borrowing rate is used. This is the rate a lessee would pay to borrow funds on a collateralized basis over a similar term in a similar economic environment.

Under ASC 842, leases are classified as either finance leases or operating leases for lessees. This classification dictates the subsequent accounting treatment.

A lease is a finance lease if it meets any of five criteria:
Ownership of the underlying asset transfers to the lessee by the end of the lease term.
The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
The lease term represents a major part of the remaining economic life of the underlying asset.
The present value of the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
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.

If none of these criteria are met, the lease is an operating lease.

Information Needed for Lease Recording

Before recording a lease, information from the agreement and calculations are needed. The lease term is a fundamental piece of information, including any noncancellable periods and periods covered by extension or termination options that are reasonably certain to be exercised or not exercised, respectively. Fixed lease payments, which are consistently paid throughout the lease term, are also essential. Variable lease payments that depend on an index or a rate, such as the Consumer Price Index (CPI), are included in the lease payments for measurement purposes.

Initial direct costs are incremental expenses incurred by the lessee that would not have arisen if the lease had not been obtained. Examples include commissions paid to a selling agent once the lease is executed, or legal fees directly related to finalizing the lease. Lease incentives, such as payments made by the lessor to or on behalf of the lessee, or losses incurred by the lessor for assuming a lessee’s existing lease, reduce the consideration in the contract. A common example is a tenant improvement allowance, where the lessor provides funds for the lessee to modify the leased space.

Residual value guarantees, if probable of being owed by the lessee, and payments related to purchase options that are reasonably certain to be exercised, are also included in the lease payments. Termination penalties, if the lease term reflects the lessee exercising an option to terminate, are also considered. The discount rate is another critical input. If the rate implicit in the lease is not readily determinable, the lessee must use its incremental borrowing rate.

With these inputs, the present value of the lease payments must be calculated. This present value forms the basis for both the initial lease liability and the Right-of-Use (ROU) asset. The initial ROU asset is then determined by adjusting this lease liability amount.

Initial Lease Recognition and Journal Entries

Initial lease recognition involves recording both a Right-of-Use (ROU) asset and a corresponding lease liability. Both finance and operating leases follow the same general journal entry for initial recognition.

The general journal entry for initial recognition involves debiting the Right-of-Use Asset and crediting the Lease Liability. For instance, if the calculated present value of lease payments is $100,000, the entry would be a Debit to Right-of-Use Asset for $100,000 and a Credit to Lease Liability for $100,000.

Initial cash payments made by the lessee to the lessor at or before the lease commencement date will increase the initial value of the ROU asset. Similarly, initial direct costs incurred by the lessee are added to the ROU asset. Conversely, any lease incentives received by the lessee reduce the initial measurement of the ROU asset. The ROU asset’s initial value is thus the lease liability plus any initial direct costs and prepaid lease payments, minus any lease incentives received.

Subsequent Lease Accounting and Journal Entries

After initial recognition, the accounting for leases differs based on their classification as either a finance lease or an operating lease. This ongoing treatment involves periodic adjustments for payments, amortization, and interest, impacting both the income statement and the balance sheet.

For finance leases, subsequent accounting involves recognizing both amortization expense for the Right-of-Use (ROU) asset and interest expense on the lease liability. The ROU asset is amortized on a straight-line basis over the shorter of the lease term or the useful life of the underlying asset. The journal entry for this periodic amortization is a Debit to Amortization Expense and a Credit to Right-of-Use Asset.

Interest expense on the lease liability is recognized each period as the liability is reduced. The journal entry for interest is a Debit to Interest Expense and a Credit to Lease Liability. When a lease payment is made, the journal entry involves a Debit to Lease Liability and a Credit to Cash, reducing the outstanding obligation.

Operating leases are accounted for differently on the income statement, presenting a single, straight-line lease expense over the lease term. This single lease cost combines the amortization of the ROU asset and the interest on the lease liability. The journal entry for the periodic lease expense is a Debit to Lease Expense and a Credit to Lease Liability (or Cash if the payment is made simultaneously). The reduction of both the ROU asset and the lease liability is implicitly handled to ensure the single lease expense is recognized on a straight-line basis.

Lease modifications, which involve changes to the terms and conditions of a lease contract, can also impact subsequent accounting. Depending on whether the modification grants the lessee an additional right-of-use not included in the original lease and if the payments increase commensurately, the modification may be accounted for as a separate new lease. Otherwise, the existing lease liability and ROU asset are remeasured, often requiring an updated discount rate, and adjusted accordingly.