A manufacturing company signs a seven-year equipment lease with no purchase option. The equipment has a ten-year useful life and a $500,000 fair value. The CFO asks whether this hits the balance sheet. Under ASC 842, virtually all leases hit the balance sheet, the question is classification, which drives the income statement pattern. The exam rewards candidates who can classify from both sides of the transaction and trace the numbers through the journal entries.
AICPA Representative Tasks (verbatim). "Identify the criteria for classifying a lease arrangement for a lessor." "Calculate the carrying amount of lease-related assets and liabilities and prepare journal entries that a lessor should record." "Calculate the amount of lease income that a lessor should recognize in the income statement." "Prepare journal entries that the seller/lessee should record for a sale and leaseback transaction." "Interpret agreements, contracts and/or other supporting documentation to determine the appropriate accounting treatment of a leasing arrangement and prepare the journal entries that the lessee should record."
Common mistakes
- Applying the 75%/90% thresholds as bright lines. ASC 842 uses "major part" and "substantially all" without fixed percentages. The 75%/90% thresholds are practice conventions, not codified rules. The exam may present a borderline case (e.g., 74% of useful life) and test whether you default to operating or consider other qualitative factors.
- Forgetting collectibility for lessor classification. A lessor meeting the five criteria still classifies as operating if collectibility is not probable. The exam will embed a credit-risk fact and ask the classification: always check collectibility before naming sales-type or direct financing.
- Using the wrong discount rate. Lessees use the rate implicit in the lease if determinable; otherwise, the incremental borrowing rate. Lessors always use the implicit rate. The exam may provide both rates and test which the lessee should apply.
Bottom line
- Lessee classifies as finance if any one of five criteria met (ownership transfer, purchase option reasonably certain, term major part of useful life, PV substantially all of fair value, specialized asset); otherwise operating.
- Both finance and operating leases appear on the lessee balance sheet under ASC 842.
- Lessor applies the same five tests: if any met and collectibility probable, classify sales-type or direct financing; if none met, operating.
- Right-of-use asset equals initial lease liability plus prepaid rent plus initial direct costs minus lease incentives received.
Exam shortcut
When a question asks for lease classification, run the five criteria in order, stop at the first "yes." For lessees, one "yes" = finance lease. For lessors, one "yes" + collectibility probable = sales-type (or direct financing if no manufacturer/dealer profit). Zero "yes" answers = operating lease for both parties. When computing Year 1 interest expense on a finance lease, multiply the initial lease liability by the discount rate.
The full lesson (about 3,026 words, 20 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- II.I1
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