Lease Accounting Explained: What It Is and Why It Is Important

The continuously increasing trend of startups with an expansion of real estate paves the way for lease agreements. According to IBISWorld, the real estate industry, including rental and leasing, witnessed a 2% growth in 2022. Businesses that cannot afford to purchase tangible items like buildings, furniture, and equipment are likely to get things on lease to meet their commercial needs. Here lease accounting comes into play to regulate the lease under state standards.

What is lease accounting?

Lease accounting covers the record-keeping and reporting of lease-related financial data. It traces the revenues and expenses of the lease and complies with accounting standards. In addition, lease accounting reflects the financial impact of lease agreements within an organization.

Lease Accounting Standards

Several regulatory organizations, such as Financial Accounting Standards Board (FASB), Government Accounting Standards Board (GASB), and the International Accounting Standards Board (IASB), formulate the accounting standards. The new lease accounting standards named the Accounting Standards Update 2016-02 (ASU-2016-02) or US GAAP ASC 842, laid the foundation for greater transparency. The FASB issued these accounting standards in 2016. After implementing the latest standards, all leases with more than 12 months, irrespective of their classification, must report through the balance sheets.

The latest lease-accounting standards are explained below:

• ASC 842, effective from 2019 for most public entities and 2021 for private enterprises, adopted a dual approach for lease accounting. It established the different classifications of leases for lessees and lessors. The ASC 842 explained the lease accounting protocols for reporting through the balance sheet. It improves the transparency of leases by reducing off-balance-sheet financial data.
• GASB 87, effective from June 2021, defined lease standards for local and state governments. Based on a single model approach, GASB 87 updated rules for capital and operating leases without any distinction. Now all leases are considered finance leases under this accounting standard. The aim of the GASB 87 is to report lease-related financial data more accurately and improve the productivity of public financial statements.
• IFRS 16, effective from Jan 2019, also adopted a single model approach and treated both capital and operating leases as finance leases. IFRS 16 is for all organizations operating at an international level. US entities working abroad, either as parents or subsidiaries, must comply with this lease accounting standard and know the difference between the IFRS and GAAP.

Classification of Leases

Every lease comes under a different category depending on the lessors or lessees. There are three accounting treatments applicable on the lease made by a lessor, while two for a lessee. The lease accounting standards defined the five tests to determine the classification of the lease. Once the lease category is determined, the accounting treatment begins.

Lessor Lease Accounting

For Lessors, leases are classified into the following categories.

• Sales-type leases mostly work as outright sales, where lessors remove the underlying asset from their balance sheet and replace it with an asset investment. For instance, when movie technology is installed in an independent theater for the 10-year to 20-year lease period, it becomes obsolete at the end of the lease. Thus, a lessor can earn no more money from the technology, making it a sale-like lease.
• Operating leases are straightforward leases where the lessors hold the assets and their depreciation value on the books and keep a record of lease payments. For instance, when lessors give space for leases such as an apartment or an office, they maintain the financial accounts on their record and report it through the balance sheet.
• Direct financing leases are a combination of the above two categories. This type of lease inclines more towards a sales-type lease, with the difference lying in the deferment of the profit or loss on the leased asset. For instance, financial institutions adopt direct finance leases to acquire assets and give them for lease to customers.

Lessees Lease Accounting

Lessee’s lease accounting has two categories that are explained below:

• Operating leases give the lessees a “right-of-use asset” where they maintain the lease liabilities on the balance sheet. Moreover, the right-of-use asset status determines the different financial reporting for leased assets as compared to company-owned assets. For instance, an operating lease is a close-ended vehicle lease, when a lessee must return a leased car after the end of the lease period.
• Finance leases are based on more like ownership status. In this type of lease, the major control of the leased asset lies with the lessees, and they are more responsible for the risks than the lessors. For instance, an open-ended vehicle lease works as a finance lease where the lessee is bound to purchase the car after the lease period.

Importance of Lease Accounting

Lease accounting is an effective process to handle lease agreements within the jurisdiction. It reflects the features of underlying leases for important decision-making. Some features include:

1. Recognition and reporting of lease liability on the balance sheet.
2. Recording and evaluating the asset at the start of the leasing period and its depreciation with time.
3. Recording of lease liability at the start and throughout the lease period.
4. Proper maintenance of financial statements such as balance sheets, cash flow statements, and income statements.

Lease accounting plays an integral role in understanding and improving the financial health of an organization. When you know how to track the expenditures and revenue coming from leased assets, you are in a better position to design a financial strategy aligning with your business goals. Moreover, you can fine-tune your business strategy to control losses and gain profits. Lease accounting empowers you to make well-informed decisions based on reporting the crucial aspects of the asset, including the market value and depreciation. In short, lease accounting is what you need for collecting key information, gaining useful insights and perspectives, and improving compliance with the regulations.

It’s essential for every company that is involved in lease activities to leverage lease accounting. Regardless of your status as a lessor or a lessee, you must understand the ins and outs of different classifications of lease accounting. In addition, you must stay updated on the latest lease accounting standards that apply to your nature of business. When you know how lease accounting fits into your business, you can use financial statements to extract accurate financial data and base your future strategies on them.

Final Thoughts

Whether your enterprise is public or private, it has to adopt lease accounting for seamless financial operations. As the lessor or the lessee, you have the best way to keep and maintain a record of assets, income, expenses, and liabilities through lease accounting. The leasing activities can impact the big picture of your business, so put it to advantage to yield benefits.