In this guide, we will cover the basics of lease accounting, answering the questions:
- What is a lease?
- What are the advantages of leasing?
- What are the disadvantages of leasing?
- What is lease accounting for a lessee?
- What changes in lease accounting do organizations need to consider when adopting the new accounting standards?
- What is the journal entry for a lease?
- How do you treat a lease in accounting?
- What are the new lease accounting standards?
Leasing: The Basics
What is a lease?
A lease is a contract under which a property or asset owner (the lessor) allows another party (the lessee) to use an identified property, plant or piece of equipment for a set period of time in exchange for compensation. The two most common types of leases for lessees are operating leases and finance leases.
How an individual or entity goes about lease accounting depends on many variables, including the type of lease and the current accounting standards. Here’s what you need to know.
Lease classifications: Operating lease vs financial lease
The two most common types of leases for lessees are operating leases and financing leases, otherwise known as capital leases. Generally, a lease qualifies as a financing lease –or capital lease – under IFRS standards when risks and rewards have been fully transferred to the lessee from the lessor. Sometimes, the lines here can be blurred, so a lease should be recorded as a financial lease if it meets at least one of the following criteria:
- Ownership is shifted from the lessor to the lessee at the end of the lease term. Alternatively, the lessee has a purchase option, and it is reasonable to believe they will use it.
- To this end, the lessor may offer a bargain purchase option, which gives the lessee an option to purchase the asset under market value at a future date.
- The lease term covers 75% or more of the asset’s remaining economic life.
- The net present value (NPV) of minimum lease payments equals at least 90% of the asset’s fair value.
- There is no alternative use for the asset following the completion of the lease term.
Otherwise, a lease is classified as an operating lease, which is a standard landlord-renter contract.
What are the advantages of leasing?
A lease is often more attractive than a loan or a purchase contract. Distinct advantages of leasing include:
- Scheduled payments that are more flexible than payments under loan contracts.
- Lower after-tax costs due to differing tax rates for lessors and lessees.
- 100% financing of the price of the asset.
- For operating leases, companies create expenses rather than liabilities, which allows for financial funding.
What are the disadvantages of leasing?
There can also be several disadvantages to leasing, including:
- Agency costs, or the separation between the asset’s ownership (lessor) and control of the asset (lessee).
- Issues with lessees
Lease Accounting: The Basics
What is lease accounting for a lessee?
Lease accounting is different for lessors and lessees. In this section, we will discuss lease accounting for lessees. At the start of a lease, the lessee is required to measure a lease’s:
- Lease liability: This is the present value of lease payments, including any discount rate.
- Right-of-use asset: This is the initial amount of any lease liability, which takes into account any any lease payments made before the commencement date and any initial direct costs incurred.
When a lessee has designated a lease as a finance lease, that lease should recognize:
- The ongoing amortization of the right-of-use asset
- The ongoing amortization of the interest on the lease liability
- Any variable lease payments that are not included in the lease liability
- Any impairment of the right-of-use asset
When a lessee has designated a lease as an operating lease, the lessee should recognize:
- A lease cost in each period, where the total cost of the lease is allocated over the lease term on a straight-line basis.
- Any variable lease payments that are not included in the lease liability
- Any impairment of the right-of-use asset
- The right lease accounting software can help with many of these documents and processes.
What changes in lease accounting do organizations need to consider when adopting the new accounting standards?
There are three new lease accounting standards: IFRS 16, GASB 87 and ASC 842. You can find more information on each standard here:
These standards follow the “right-of-use" model, which stipulates that if a company has the right to use an asset they are renting, it is classified as a lease for accounting purposes – and thereby must be recognized on the company’s balance sheet.
This change closes the loophole that allowed some significant financial liabilities to be held off balance sheet, with the goal of bringing increased transparency to lease asset reporting and liabilities.