Why lease payments does not equal lease expense
To answer that question, you must understand how the calculations work for an operating lease under ASC 842. So we encourage you to read on.
The quick summary is that the lease expense is the total lease payments straight-lined over the life of the lease. As a result, for most leases, the lease payments incurred over a certain period will not be equal. However, over the entire life of the lease, they will.
Deloitte, in their ASC 842 guide, A Roadmap to Applying the New Leasing Standard on p.327, has a great example that articulates this principle:
Per the above example, the Lease Cost of $15,419 never once equals the Lease Payment amount starting at $15,000.
Read on if you want a nuanced explanation of how the above calculation works. Or just let Cradle handle it 🧘♀️.
Calculation of interest on the lease liability and the difference between a finance lease
The interest calculation on the lease liability does not change if it’s an operating or finance lease. The critical difference is that under an operating lease, it’s recognized as a lease expense and not an interest expense.
So that’s the lease liability taken care of. What about the right of use asset?
How the right of use asset lease expense works and the difference between operating lease and finance lease
First off, there are two ways to calculate the lease expense for the right-of-use asset. For more details on that, refer to this article — How to Calculate the Right of Use Asset Amortization and Lease Expense Under ASC 842.
Unlike a finance lease, the lease expense for an operating lease is a straight-line amount which is classified as a single lease cost. This treatment is detailed specifically in ASC 842-20-25-6.
To achieve this, in calculating the right-of-use asset amortization, you must calculate the total lease expense and subtract the interest amount to get a lease expense.
How to calculate the total straight-line expense
This is total interest incurred (1) + ROU lease expense (2) incurred for the entire lease = total payments made for the lease.
This is the interest calculated on the lease liability. For more information on how that works refer to the article How to Calculate the Lease Liability and Right-of-Use Asset for an Operating Lease under ASC 842.
This is the straight line lease expense (total payments divided by total days) less the interest expense
What does this calculation methodology mean? The actual lease payments will not equal the lease expense for that applicable period.
Example by Deloitte
Deloitte, in their ASC 842 guide, A Roadmap to Applying the New Leasing Standard on p.327, has a great example that articulates this principle:
We’ve also formula linked this calculation, which you can refer to here.
Example by Cradle
You may have noticed that the lease liability does not go to zero in the Deloitte example. That’s one of the shortcomings of calculating the lease monthly. So instead, in Cradle, we calculate a daily straight-line lease expense. For more on that, refer here.
Chart of Accounts
Because the operating lease expense is recorded in a single financial statement line item, this accounting treatment is reflected in Cradle's Chart of Accounts. There's only one lease expense for an operating lease.
For a finance lease, you will input the chart of accounts for interest on the lease liability and amortization of the right-of-use asset.