Lease Accounting

What Is Lease Accounting?

The method by which companies report the financial effect of agreements to rent or finance the rights to use specified assets is known as lease accounting, also called leasing.

Lessees and lessors must now account for and disclose their leases in accordance with the latest accounting standards, such as ASC 842.

The Financial Accounting Requirements Board (FASB) in the United States, IASB worldwide, and GASB for state and local governments in the United States all maintain lease accounting reporting standards.

The phrases "lessee" and "lessor" refer to the parties engaged in a lease contract. This distinction is critical because accounting as a lessor differs significantly from accounting as a lessee.

While the core concepts of lessor and lessee remained, introducing new lease accounting rules led to changes in their accounting treatment. However, the new lease regulations have changed part of the accounting treatment for lessors and lessees. So:

• A lessee is an entity that pays a lessor to use a certain piece of property. When a person leases a car from a dealership, for example, the lessee is the one who drives the automobile. The lessee effectively pays the lessor for the "right to utilize" the asset. This is why, under the new lease rules, the lessee must account for the lease as an intangible "right-of-use asset" (ROU asset) or "lease asset."

• A lessor is an entity (i.e., a person, corporation, or organization) that provides the right to use an asset for a specific time in return for a fee.

One of the most prevalent leasing agreements involves an entity renting its after-is last property to another business in exchange for a monthly cash payment.

For example, if an organization owns a building and leases the right to use the building or a portion of the structure, the lessor, often known as the landlord, is the facility's owner.

Lessor Accounting for Capital Leases

When the carrying value and lease payments are the same, the lessor records a capital lease as a direct finance lease under US GAAP. The lessor records a sales-type lease if the present value of the lease payments exceeds the asset-carrying value.

Four criteria establish whether a lease is a capital lease or an operating lease under ASC 840-25-1. Upon signing the lease, this evaluation will be completed. Many businesses perform these four tests. Therefore, we've summarized them below:

• The first condition is whether the title/ownership of the property passes to the lessee after the lease period.
• The second test involves assessing whether the lessee has the option to purchase the leased property at a bargain price.
• Third, is the lease period 75 percent or more of the asset's remaining economic life?
• The fourth test checks whether the present value of the total lease payments is 90% or more of the underlying asset's fair value at the lease's inception.

Lease Accounting Transition from ASC 840 to ASC 842

ASC 842 provides a practical shortcut that allows a corporation to grandfather lease categories for leases that started before the shift. 

The FASB has said that organizations who choose this practical expedient must verify that their accounting complies with ASC 840, as this expedient was not designed to allow companies to grandfather accounting mistakes. 

As a result, while ASC 842 is in effect, lessees must understand their lease categories under ASC 840.

The lessor records both forms of financing leases in the following ways on its financial statements:

• The lessor presents the lease receivable on the balance sheet based on the present value of the lease payments.
• The lessor reports interest revenue based on the lease's receivables and the interest rate at the start of the loan on the income statement.
• The lessor reports the interest component as operating cash flow and the principal part as financing cash flow on the cash flow statement.

Finance (Capital) Lease Example

Skidz, Inc., has signed a six-year leasing agreement with Bob's Construction Supply for a tower crane valued at $1,100,000. The crane has a seven-year usable life expectancy. 

According to the contract, Skidz, Inc. will pay the lease payment at the end of each month for the next six years, with an implied annual interest rate of 12%. 

There is no salvage value after the lease period. However, Skidz Inc. can purchase the crane for less than its fair market value (FMV). Skidz will pay a monthly fee of $20,000 (actual: $19,886.56).

The contract fits the following bright-line conditions for a capital lease:

• During the lease, Bob's Construction does not transfer ownership of the crane to Skidz, Inc.
• At the end of the lease, Skidz, Inc. has the opportunity to purchase the crane for less than FMV
• The lease period is 6/7 of the crane's economic life (86%) instead of 75%
• The current value of the monthly leasing rental is 94 percent, which is more than the required 90%

The present value for computing lease payments is $1,034,000 at 94%. The total rent paid throughout the contract (72 months) is $1,431,840 (approximated based on the given monthly payment). 

To calculate the interest, divide the total by the principal and interest charge:

Interest = Total Rent Paid - Loan Amount Calculated

The crane's depreciation was divided into 72 monthly installments by the accountants. As a result, the crane's monthly depreciation is:

Depreciation = Present Value / 72

= 1,017,205 / 72 = 14,128$

Skidz, Inc. pays to clear the finance lease principal and interest over the 6-year loan under a capital lease accounting arrangement. In the lessee's books, the first period looks like this:

Lessor Accounting for Operating Lease

The lessor records the leased asset on the balance sheet and the interest revenue and asset depreciation on the income statement in operating lease accounting. The lease payment is shown as a cash inflow on the lessor's cash flow statement.

A corporation must pass the operating vs. finance lease test to qualify for an operating lease. Compared to a financing lease, the lessor should be aware that an operating lease often means:

• Later years will see an increase in cash flow
• In the beginning, it will have a lower cash flow
• Its taxes are reduced in the early years of the operating lease

In an operating lease, the lessee must recognize:

• The entire lease cost is allocated in a straight line throughout the lease term in each period
• The lease payments that are not included in the lease liability are variable
• Any asset with a right of use (ROU) impairment

The lessor retains all the asset's benefits and obligations in an operating lease. The lessee only utilizes the asset for a portion of its useful life.

Operating Lease Example

Trax, Inc. signs an operational lease deal for its warehouse facility, paying $17,000 in rent over 12 months. 

Because this is an operating lease, Trax, Inc. will record the lease on its records similarly for the whole year. Therefore, the cost of renting it every month is:

Monthly Rental Expense = (Overall Lease) / Number of Months in the Lease

= 17,000 / 12 = 1,416.67

This transaction's journal entry is as follows:

When calculating the cost of an operating lease, the following pattern is used:

• A single lease cost is computed such that the remaining lease cost is allocated throughout the entire lease period on a straight-line basis (FASB)
• The interest charge and right of use (ROU) amortization will be combined into a single expenditure that will be recorded on a straight-line basis
• The implicit rate or the incremental borrowing rate is used to calculate the ROU amortization
• Divide the undiscounted payments by the lease duration to get the straight-line lease expenditure

Difference Between Old and New Lease Accounting Standards

The shift from old to new lease accounting standards marks a significant transformation in how companies handle and disclose their lease agreements in their financial statements.

The previous standard, referred to as ASC 840 (or IAS 17 for international entities), categorized most leases as operating leases, often leaving lease-related assets and liabilities off the balance sheet.

This practice created a situation where companies carried substantial off-balance sheet obligations, posing a challenge for investors and stakeholders in accurately gauging a company's true financial standing.

In contrast, the introduction of the new lease accounting standard, ASC 842 (or IFRS 16 for international entities), brings about a substantial change by mandating companies to recognize the majority of leases on the balance sheet.

The primary goal of this change is to enhance the comparability of financial statements and offer stakeholders a more lucid understanding of a company's lease-related financial responsibilities.

By requiring companies to include lease assets and liabilities on the balance sheet, the new standard aims to simplify evaluating a company's financial health for investors and stakeholders.

This move is expected to contribute to more informed decision-making processes as stakeholders gain improved visibility into a company's overall financial position.

Benefits Of The New Lease Standard

The recently implemented lease standard brings forth numerous advantages for companies, investors, and stakeholders alike.

One of the key benefits lies in the on-balance sheet recognition of lease obligations, offering investors a more precise and comprehensive understanding of a company's financial well-being.

Beyond its impact on investors, the new standard benefits companies by enhancing their insight into lease obligations.

This heightened visibility can empower businesses to make more informed and strategic decisions, leveraging a clearer understanding of their financial commitments in the leases.

Furthermore, adopting the new lease accounting standard promotes consistency and transparency in financial reporting. This standardization across different industries and countries catalyzes establishment of a uniform framework, facilitating the easier comparison of financial statements.

This aids in fostering a more cohesive and understandable finance, benefitting stakeholders by providing a consistent basis for assessing companies' financial positions.

Researched and authored by Fatemah Kamali | LinkedIn

Free Resources

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