Prior to the adoption of ASC 842, lease classification determines not only how lease expense is recorded in the income statement, but also whether a lessee is required to record an asset and a liability associated with its obligations under the lease. Classification is based on a number of criteria, including specific bright lines and numerous interpretations. Lessees often prefer operating leases because recognition of the underlying asset and associated lease liability is not required and rent expense is recognized on a straight-line basis over the lease term. A capital lease requires the lessee to reflect an asset and corresponding lease liability equal to the present value of the future lease payments.

A lessor always reflects lease-related assets on its balance sheet; for operating leases, a lessor records the asset under lease; for leases classified as either sales-type or direct financing, a lessor derecognizes the leased asset and records its net investment in the lease (equal to the present value of the lease payments expected to be received over the lease term and the present value of the unguaranteed estimated residual value of the asset at the end of the lease term).

Under ASC 842, virtually all leases will require balance sheet recognition as a right-of-use asset and lease liability. However, lease classification will impact the amount and timing of lease income and expense.

This chapter discusses the different types of leases, lease classification criteria, and the effect of various features and terms on lease classification under ASC 842. The accounting for leases is discussed in LG 4.