Lease Accounting

What is Lease Accounting?

Lease accounting is the systematic process that organizations follow to record the financial consequences of their lease agreements. Under recent accounting standards, most leases, including operating leases, must now be reported on the balance sheet.

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Various accounting boards maintain these standards, including:

ASC 842 (Financial Accounting Standards Board) for the United States.

IFRS 16 (International Financial Reporting Standards) maintained by the IASB internationally.

GASB 87 (Governmental Accounting Standards Board) for US state and local governmental entities.

SFFAS 54 (Statement of Federal Financial Accounting Standards) maintained by the FASAB for US federal entities.

Understanding Lessee vs. Lessor

Before delving into lease accounting, it’s essential to differentiate between the two key parties in a lease agreement: the lessee and the lessor.

  • Lessee: The lessee is the entity that pays for the use of a specific asset owned by the lessor. They are essentially renting the asset for a specified period. Under the new lease standards, the lessee is required to recognize a “right-of-use asset” or a “lease asset” on their balance sheet, which is classified as an intangible asset.
  • Lessor: The lessor, on the other hand, is the entity that provides the right to use an asset to another party in exchange for consideration. They are the owner of the asset. The lessor may recognize lease income based on the lease type.

Lease Accounting Under Old and New Standards

Historically, lease accounting standards included ASC 840, IAS 17, and various GASB standards, mainly GASB 13 and GASB 62. Under these old standards, operating leases did not significantly impact the balance sheet, while capital leases (or finance leases) were recognized on the balance sheet.

The new lease accounting standards—ASC 842 (for US GAAP), IFRS 16 (for international standards), and GASB 87 (for governmental entities)—require organizations to report most leases on the balance sheet. The primary changes include:

  • Recognizing lease assets and lease liabilities for most lease arrangements.
  • Classifying all leases as finance leases under IFRS 16.
  • Differentiating between lessee and lessor accounting treatments.

Types of Lease Accounting: Operating vs. Financing Leases

There are two main classifications of leases: operating leases and financing leases (formerly known as capital leases). The key difference between them lies in whether the lessee gains the risks and rewards associated with the asset.

Operating Lease:

  • Lessee: Recognizes lease payments as operating expenses on the income statement. No asset or liability is recorded on the balance sheet.
  • Lessor: Recognizes lease income over the lease term.

Financing Lease:

  • Lessee: Records the leased asset as an asset and a corresponding liability on the balance sheet. The liability represents the present value of lease payments. Lease payments are allocated between reducing the liability and recognizing interest expense.
  • Lessor: Derecognizes the leased asset from the balance sheet and records the lease receivable. Recognizes interest income over the lease term and allocates lease payments accordingly.

Challenges and Benefits of Lease Accounting

Challenges:

  • Transitioning to new lease accounting standards can be complex and resource-intensive.
  • Identifying embedded leases within service contracts can be challenging.
  • Incorrect lease accounting can lead to regulatory issues, increased audit costs, and reputational damage.

Benefits:

  • Improved transparency and visibility of a company’s financial obligations.
  • Enhanced comparability and transparency among organizations.
  • Streamlined processes and data accuracy in lease management.
  • Greater collaboration between departments involved in leasing activities.

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