Operating Lease Accounting Under ASC 842, Explained

The present value of the lease payments is the lease liability and initial ROU asset value.

PV = $80,000 × [1 – (1.05)^(-4)] / 0.05 = $80,000 × 3.54595 = $283,676.

Initial ROU asset and lease liability are both $283,676.

Year 1 book expense – finance lease:

• Interest expense: $283,676 × 0.05 = $14,184
• Depreciation: $283,676 ÷ 4 = $70,919
• Total expense = $85,103

Year 1 expense if operating lease:

• Straight-line rent expense = $80,000

The finance lease front-loads expense: Year 1 book expense exceeds the operating lease expense by $5,103.

Year 1 tax deduction: $80,000 (rent payment). Taxable income is higher than book pre-tax income by the same $5,103 because the tax deduction ($80,000) is less than the book expense ($85,103). The company pays more cash tax today relative to the book tax expense on the income statement, creating a deferred tax asset (DTA).

DTA = $5,103 × 25% = $1,276 (rounded).

Tax journal entry at end of Year 1: Assume pre-tax book income before the lease is X. Book pre-tax including lease = X – 85,103. Current tax payable = (X – 80,000) × 25%. Total income tax expense (book) = current tax – DTA creation = (X – 80,000)×25% – 1,276.

• Dr Income tax expense (to P&L) = (X – 80,000)×25% – 1,276
• Dr Deferred tax asset = 1,276
• Cr Cash / Taxes payable = (X – 80,000)×25%

The DTA will reverse in later years when the sum of depreciation and interest falls below $80,000, making book expense lower than the tax deduction.

Follow-up pressure:

• Explain why the DTA is $1,276 specifically from the $5,103 difference rather than from the entire $80,000 tax payment, and walk me through where that $5,103 comes from in the balance sheet accounts themselves.
• If the tax rate increased to 30% immediately after inception, would your DTA at the end of Year 1 still be $1,276, and what exact adjustment would you make to the journal entry?
• You said the DTA reverses when book expense falls below the tax deduction: show me the exact Year 3 book expense, the difference versus the $80,000 deduction, and the specific DTA reversal entry for that year.