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.
FAQ: Lease Accounting
What is the journal entry for a lease?
Journal entries are documents that record the transactions between the lessees and lessors. Generally, both parties should record journal entries. The contents of a journal entry will vary depending on if the entry is completed by the lessor or the lessee and depending on if it a capital or operating lease.
Lessee entries for capital leases should include:
- The total amount of the lease payable, taking into account debit and lease payable account credit.
- Transfer of depreciation to depreciation accumulated account
- Payment of lease obligation and interest.
- Lessee entries for operating leases should include:
- Rent of lease account debit
- Cash account credit
How do you treat a lease in accounting?
Leases are subject to different accounting treatments depending on if they’re capital leases or operating leases. Accounting for an operating lease is more straightforward, as operating statements are simply expensed on the income statement. In this case, depreciation is not assessed. A capital lease, on the other hand, involves a transferring of ownership. The lease, then, is considered a loan – and interest payments are expensed. Depreciation must also be considered and charged on the income statement.
What is the new lease accounting standard?
There are three new accounting standards: IFRS !6, ASC 842 and GASB 87:
- IFRS 16: IFRS 16 is a leasing standard that was issued by the International Accounting Standards Board (IASB) in January 2016. It went into effect on January 1, 2019.
- ASC 842: ASC 842 is the latest FASB lease accounting standard that public companies were required to adopt in 2019 and that private companies must adopt in 2020. ASC replaces the US GAAP lease standard ASC 840.
- GASB 87: GASB Statement No. 87, or GASB 87, is the latest lease accounting standard issues by the Government Accounting Standards Board (GASB) for governmental organizations. Though the current expected due date for GASB 87 adoption is June 15, 2021, GASB favors early adoption, so it’s important that your organization develops the policies, efforts and controls to facilitate adoption as soon as possible.
Learn more about lease accounting software here.
