The Only Guide You Need to Understand Lease Accounting
Last Updated on February 9, 2023 by Morgan Beard
Accountants know lease accounting has undergone drastic changes due to the enactments of ASC 842 and IFRS 16. The financial impact of the new standards is expected to be significant, and accounting tactics have needed to adjust accordingly.
Lease accounting is a critical tool for businesses that lease property or equipment. Those accounting professionals who understand it can save their organizations money and guide them to more informed financial decisions. They can also help their businesses negotiate better lease terms, lease incentives, and avoid potential financial pitfalls.
In this guide, we will provide basics on lease accounting compliance for those looking for a refresher on this complex but essential aspect of corporate accounting. We’ll also walk through everything accounting departments need to know about these two new lease standards. Whether you’re just getting your feet wet with lease accounting or already knee-deep in prep for 2023, this guide is for you!
What is lease accounting?
On a global level, lease accounting is a branch of accounting that deals with the recognition, measurement, and disclosure of lease transactions. Lease accounting aims to provide accurate and timely information to company heads to make informed decisions about those leases. On a company level, it’s an organization’s standard for tracking and reporting lease agreements.
In the U.S., lease accounting is guided by Generally Accepted Accounting Principles or GAAP, which dictate how financial statements should be prepared. Internationally, they are guided by IFRS.
Let’s start with some definitions.
ASC 842 defines a lease as:
“A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”
IFRS 16 similarly defines a lease as “a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.”
So what is a leased asset?
Common examples of leased assets would be:
- Real estate
- Medical equipment
- Fitness equipment
- IT equipment
- Yellow iron construction equipment
Which standards define lease accounting?
Lease accounting standards are set by the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) internationally.
ASC 842 went into effect on December 15, 2021, replacing ASC 840 in the U.S. IFRS 16 went into effect for international corporations on January 1, 2019, superseding IAS 17. All public business entities, private organizations, and non-profits are working to make the required changes under the appropriate accounting treatment.
Under ASC 842, or the U.S. GAAP standard, there are now two types of leases: finance leases and operating leases. The one exception to ASC 842 is leases with terms 12 months or under, also known as short-term leases, which may still be recorded as operating leases.
The new IFRS 16 standard provides a single lessee accounting model, treating all leases as finance leases to be reported as assets and liabilities. There are two exceptions to this model. The first is similar to the ASC 842 model. Leases with terms of 12 months or fewer need not be recorded as assets and liabilities. The second exception is that “low-value leases,” generally recognized as under $5,000, can also be left off the balance sheet.
What did ASC 842 determine about lease accounting?
ASC 842 requires lessees to recognize operating leases on their balance sheets as assets and liabilities and to disclose information about those leases in the footnotes of their financial statements. The goal of the standard is to provide greater transparency about a company’s operating leases so that investors and other users of financial statements can better understand a company’s financial position and performance. The new standard should make comparing companies’ operating lease expenses easier across industries.
What determines whether a contract is a lease?
As opposed to IFRS, which classifies all leases as finance leases, ASC 842 splits leases into operating leases and finance leases. Both of them feature these same two players.
The lessor is the party that conveys the right to control the use of the asset for an agreed-to term and payment, otherwise known as the Landlord. The lessee is the party that makes the payment, also known as the tenant.
Let’s first consider a landlord/tenant relationship. Under ASC 842, this would be considered an operating lease. Let’s look at the parties and review the terms.
If ABC Real Estate offers a three-year space lease of $5,000 per month to XYZ Industries, we have:
Contract: Operating lease
Lessor: ABC Real Estate (landlord)
Lessee: XYZ Industries (tenant)
Asset: Right-of-use space lease
Term: 3 years
Consideration: $5,000/monthly payment
Now let’s look at a fitness equipment finance lease.
Springfield Medical takes on a two-year $100,000 finance lease of medical equipment from PAY-US Bank
We now have:
Contract: Finance lease
Lessor: PAY-US Bank
Lessee: Springfield Medical
Asset: Right-of-use of medical equipment
Term: 2 years
Consideration: $2,300/monthly payment
If everything looks similar to the operating lease example, it should! These two agreements are quite similar. Where they differ is in how your organization classifies the leases.
Recording finance leases vs. operating leases
With this broad definition of “lease” under the new accounting guidelines, organizations recognize lease payments as expenses on their income statement over the life of the lease.
Let’s start by defining a finance lease so you can understand what should and shouldn’t be on the books. A finance lease is any lease that meets at least one of the following conditions:
- A planned transferral of ownership of an asset to the lessee at the end of the term.
- The lessee is reasonably sure that they will exercise a purchase option at the end of the term.
- The leased asset has no alternative use to the lessor at the end of the term.
- The lease term is a significant part of the economic life of the underlying asset (most organizations continue to use 75% as a guiding number).
- The present value of lease payments is a substantial amount of fair value of the leased asset (most organizations continue to use 90% as a guiding number).
We defined a finance lease first because that makes an operating lease relatively easy to explain. An operating lease is any lease that a finance lease is not. Most space leases, like office buildings or retail storefronts, are operating leases because there is no plan to transfer the property to the lessee.
Accounting Standards Codification (ASC) has made it relatively difficult to record anything other than space leases and short-term leases (under 12 months) as operating leases. And this is intentional. The goal is to provide investors with a more accurate picture of a company’s financial performance.
Financial statements used to document a lease
Three financial statements must be used to record your leases correctly. They are:
Balance sheets: shows a company’s assets, liabilities and shareholder equity. A lease will be recorded on a balance sheet as an ROU asset and lease liability.
Income statements: shows a company’s profit and loss over a given period. Lease payments are shown as an expense.
Cash flow statements: shows how much cash is generated and used during a given period. On the cash flow statement, leases are now recorded as a right-of-use (ROU) asset. Record it as an interest expense on the lease liability and as a depreciation expense on the right-of-use asset.
In addition to these three financial statements, there are two primary lease accounting measurements you’ll need to calculate:
Lease amortitization schedules: shows your lease payments, any initial direct costs, and lease incentives and streamlines the present value calculation for your lease liability as well as your ROU asset over the lease term.
Journal entries: records your monthly balance of lease liabilities and ROU assets debited or credited as a straight-line expense throughout the month.
Why do companies choose to lease?
It helps to get some perspective on why companies lease. There are several advantages to leasing, though recent standards have transformed those motivations.
Leases often come with built-in maintenance and repair provisions, saving businesses money over the lease term. Property leases can be structured in various ways to suit the tenant’s needs, including offering deferred rent or options to renew or terminate the lease early. They can also be a flexible and cost-effective way to acquire the use of property or equipment. Many companies lease their buildings or equipment instead of purchasing them outright. There are several reasons for this, including that leases often have lower upfront costs and give companies more flexibility in locating their operations.
Leasing can be an attractive option for companies looking to conserve capital or test opening their doors in a new market. Organizations were habitually using operating lease accounting to keep leased assets off their balance sheets to provide their investors with a rosier economic outlook. They gave banks inaccurate views of their debt levels while maintaining a solid credit rating.
ASC 842 and IFRS 16 were implemented to bring all leases on the books and ensure all interested parties had transparency regarding an organization’s financial outlook.
ASC 842 requires lessees to record operating leases on the balance sheet as a right-of-use asset and corresponding lease liability. Operating leases must be recorded as a right-of-use asset on the balance sheet and a corresponding lease liability on the income statement. Thus, the right to use the asset is an asset to be recorded rather than the asset.
The lessee records a right-of-use asset on their balance sheet for the property’s future use. For operating leases with a term of 12 months or less, businesses can choose not to record a right-of-use asset on their balance sheet. Operating leases with a term greater than 12 months must be recorded as a right-of-use asset and corresponding lease liability on the lessee’s balance sheet. At the expiration of the lease, the lessee will generally have the option to purchase the leased property from the lessor for its fair market value. If the lessee exercises this purchase option, they would remove the right-of-use asset and lease liability from their balance sheet.
The implications of IFRS 16
We have mainly discussed ASC 842 as it applies to GAAP standards domestically. We’ll now discuss IFRS 16 for any organizations that follow the international standard.
As mentioned, IFRS 16 went into effect on January 1, 2019. It required lessees to bring most operating leases onto the balance sheet as a right-of-use asset and a corresponding lease liability. Before this, operating leases were not recorded on the balance sheet.
Lessees will recognize an operating lease ROU asset and corresponding liability for each operating lease at the commencement date. The operating lease ROU asset represents the lessee’s right to use the underlying asset during the lease term.
The operating lease ROU asset is initially measured at cost, the present value of future minimum lease payments not paid at or before the commencement date, discounted using the interest rate implicit in the lease. As with ASC 842, there is a short-term lease exception: for operating leases with a term of 12 months or less, a lessee may elect to recognize all lease payments in profit or loss on a straight-line basis. No operating lease ROU asset or liability is recognized if this election is made.
The main practical difference between pre-and post-IFRS 16 operating leases is that lessees will now have an operating lease ROU asset and corresponding liability on their balance sheet. This change leads to additional disclosures in the financial statements about operating leases. In addition, some covenants in agreements (such as debt agreements) that use EBITDA as a performance metric may need to be revisited because EBITDA will no longer exclude operating lease payments. Finally, there could be tax implications due to recognizing an operating lease ROU asset and corresponding liability on the balance sheet.
Some of the top challenges for accountants
The first major challenge is data accuracy. Accounting teams will need to find embedded leases and ensure that the real estate and equipment lease data is up-to-date. With ASC 842 and IFRS 16, all leases, operating and finance, must be on the balance sheet.
Another one of the most significant challenges for businesses with a high volume of leases is tracking payments and deadlines. A third challenge is correctly categorizing leases as either operating or finance leases.
Finally, lease accounting requires businesses to calculate such items as an asset’s expected life and the interest rate used to discount future lease payments. These estimates can be challenging and significantly affect the bottom line.
Investing in the appropriate software and consulting qualified accountants familiar with the new standards is crucial here.
Given the recent changes enacted by ASC 842 and IFRS 16, the future of lease accounting is clear on paper but potentially chaotic in operation. Understanding these basics will ensure you can guide your organization into the new year with the ability to document leases properly. This blog post outlines what lease accounting is, which standards define it, and the distinct elements involved in a lease. We also discussed how to record finance leases versus operating leases on your financial statements and the implications of both IFRS 16 and ASC 842. Be sure that you are recording your right-of-use assets and that you understand the exceptions to both new standards!
Please get in touch with us if you have questions about lease accounting or want more information. We’re here to help!