Your Expert Guide to Lease Accounting (2024)

Leasing assets is a common practice for companies of all sizes and industries. Among theirmany advantages, leases increase businesses’ purchasing power, decrease maintenancecosts (if the lessee isn’t responsible for maintenance) and help better manage cashflow. However, accounting for leases has become an issue for many companies due to newaccounting rules that began in 2019 for publicly traded companies and took effect at the endof 2021 for private companies.

These changes to lease accounting rules are particularly extensive for lessees, even thoughthe core principle of classifying leases based on how much they’re like an outrightsale remains intact. The changes include big philosophical shifts along with many smalladjustments, with the primary change being that lessees are now required to carry theoperating leases on their balance sheets if they last more than 12 months — the designis to give investors a better understanding of a company’s long-term liability.Complying with the new rules has proven to be more difficult than anticipated, especiallyfor companies without the right accounting systems in place.

What Is a Lease?

A lease is a contract between two parties for the temporary use of an asset in return forpayment. Businesses use many types of leases, tailoring them to include details specific toeach agreement. Leases can involve all kinds of assets, from property, such as officebuildings, to equipment, such as computers, cars, trucks and factory machinery. A leasecontract documents key terms for each lease and is signed by both parties: the lessor andthe lessee.

• What is a lessor? The lessor is the entity that owns the asset beingleased. Lessors receive payment in return for giving up their right to use the assetduring the lease term, although they maintain ownership.
• What is a lessee? The lessee is the entity that pays the lessor for useand day-to-day control over a leased asset during the lease term, in accordance with thelease agreement.
• Lessor vs. Lessee: The lease agreement describes the obligations ofboth lessor and lessee. Breaching these terms can cause early termination by eitherparty. Typical lessor and lessee obligations are compared below:

Leases differ from rental agreements in many ways but the two most significant are durationand control. Rentals tend to be short-term — typically 30 days, max — whileleases skew longer, often measured in years. Short-term leases have a duration of 12 monthsor less and lease accounting rules do not apply to them. Ultimate control of an asset, as inmaintenance or modification, remains with the asset owner for rentals, but leased assets aretypically controlled and maintained by the lessee.

What Is Lease Accounting?

Lease accounting refers to the treatment of lease-related revenues and expenses for financialrecord keeping and reporting. Accounting standards from several rule-setting organizations,including the Financial Accounting Standards Board (FASB) and Government AccountingStandards Board (GASB) in the U.S., and the International Accounting Standards Board (IASB),govern how leases are classified for accounting purposes.

Lease accounting aims to properly reflect the true nature of the underlying lease agreementfor key considerations, including:

1. Proper recognition of lease liability on a lessee’s balance sheet.
2. Recording and properly valuing the asset at inception and as that value changesthroughout the duration of the lease.
3. Recognizing and valuing lease liability at inception and as that liability changesthroughout the duration of the lease.
4. Proper recognition of income statement aspects, such as lease revenue and expenses andprofits and losses on leased assets.

Lessee vs Lessor Accounting: Lessors have three possible accountingtreatments that may be applicable to a given lease while lessees have two. Selecting theappropriate lease accounting treatment begins with determining the classification of alease, using five tests defined by the accounting standards. Once the designation isdetermined, the lessor makes certain journal entries and disclosures and the lessee makesothers.

Lessors classify leases as either sales-type leases, direct financing leases or operatingleases, based on the tests included in the standards. The more the lease resembles anoutright asset sale, the more a lessor’s initial accounting mirrors that of a sale.

• For sales-type leases, which are, as you might guess, most like anoutright sale, lessors “derecognize” the underlying asset — whichsimply meansthey remove it from their balance sheet — and add a new asset to their balancesheet in its place: an investment in the lease. Also, at this point, the lessorwould recognize any profit or loss on the asset. Over the duration of a sales-typelease, the lessor records interest income and reduces the balance of the leaseinvestment as they receive payments from the lessee. Sales-type leases are foundoften in the entertainment business, where movie theater technology is leased toindependently owned theaters. Once the technology is installed in the theater, thelessor effectively transfers total control and responsibility for it to the lessee,usually for a 10- to 20-year lease term. At the end of the lease, the technology islikely to be obsolete, and therefore of no remaining value to the lessor. Inreality, the lease is very much like a sale, which is why the movie-theatertechnology asset is removed from the balance sheet and replaced by the leaseinvestment asset.

• For operating leases, which are the least sales-like, lessors retainthe asset and related depreciation on their books and simply record lease payments.A straightforward example is a lease for office space in a high-rise building withmultiple occupants. Since this is more like a rental than a sale, the lessor retainsthe building and related accounts, like a depreciation account, on its balancesheet.

• Direct financing leases can be thought of as in between sales-typeleases and operating leases, although much closer to sales-type. With this type oflease, the lessor’s accounting works similarly to a sales-type lease butdefers any profit or loss on the asset because it’s not quite an outrightsale. This is the type of lease used by most financial institutions that acquireassets simply to make money from leasing them to customers.

Lessees can classify leases as either an operating lease or a finance lease, based on testsincluded in the standards. For lessees, the tests are meant to gauge the relationship withthe underlying asset, determining how similar the lease is to true ownership. There aredifferent accounting treatments for the two types of leases in the US version of the newstandard, which is known as a “dual approach.”

• In the case of finance leases, where the relationship is more likeownership — meaning, the risks and control of the asset lies mostly with thelessee. An open-ended vehicle lease, where there is an obligation to purchase thecar at the end of the lease, is an example of a finance lease.

• In an operating lease, the lessee records a “right-of-useasset” anda lease liability on their balance sheet. A right-of-use asset designationdistinguishes leased assets from a company-owned assets, which is especiallyrelevant for financial reporting purposes. As lessees make payments over the leaseterm, they amortize the asset, reduce the lease liability and recognize interestexpense on their income statements. A closed-end vehicle lease, where the car mustbe returned to the lessor at the end of the lease, is an operating lease.

Key Takeaways

• Because leasing can give companies access to resources they couldn’t otherwiseafford, increase businesses’ purchasing power and assist in managing cash flow,it’s common among companies of all sizes and industries.
• New accounting standards aim to increase transparency of leasing activity on alessee’s financial statements by eliminating prior “off balance sheet”treatment.
• Compliance with the new standards has already caused a dramatic increase in accountingburdens, especially for international and public companies.
• The right lease accounting software saves time and minimizes the risk of errors,relieving the compliance burden for many companies.

Lease Accounting Explained

Five criteria for classifying a lease constitute an important part of the lease accountingstandards. The objective of these criteria is to characterize the nature of the lesseebusiness’s relationship with the underlying asset. The more akin to ownership controland an outright purchase, the more comprehensive the accounting will be for both lessor andlessee. The five criteria used to classify a lease are:

1. Does ownership transfer at the end of the lease?
2. Is there a “bargain purchase option” — i.e., a price significantlylower than theexpected market value — for the leased asset that is reasonably certain to beexercised?
3. Does the lease term cover the major part of the remaining economic life of the asset?
4. Is the present value of the lease payments (plus any residual value guarantees) greaterthan or almost equal to the fair value of the asset?
5. Is the asset very specialized, so can’t be used by the lessor at the end of theterm?

The criteria are similar in nature in the old and new lease standards, but the new standardseliminate specific thresholds (sometimes called “bright lines”) for numbersthree and four.Instead, they now rely on professional judgement.

Lease Classifications or Types

Classification of leases is important because the accounting treatment for both lessor andlessee is different for each classification. Using the five criteria explained in the priorsection, leases are classified as follows:

• Sales-type: If a lease meets any one of the five criteria, it is asales-type lease for the lessor and a finance lease for the lessee.
• Direct financing: If it doesn’t meet any of the five criteria,but the risks and rewards similar to ownership transfer to the lessee and the value ofthe lease (including the residual) does not trigger profit to the lessor, it’s adirect finance lease for the lessor and a finance lease for the lessee. The technicalfine print on measuring whether profit exists is similar to criterion number four, butinstead of “greater than or almost equal to” the fair market value of theasset, thepresent value of the lease payments is “less than or equal to” that valueandcollectability of any residual value is probable.
• Operating lease: If a lease does not meet any of the criteria, it is anoperating lease for both the lessor and the lessee.
• Operating lease vs capital lease: Evaluating whether a lease wasoperating or capital, a classic test question for accounting 101 students, is nowoutdated since the new standards no longer include capital leases, which have beenreplaced by finance leases.

Lease Accounting Standards

One of the main goals of the new lease accounting standards is to eliminate off-balance-sheettreatment of operating leases. Under the old standards, a lessee’s liability forfuture amounts owed under operating lease contracts did not appear on its balance sheet.Instead, the liability was disclosed only in footnotes to financial statements. Thistreatment understated total liabilities on the financial statements, thus skewing somefinancial analyses, including debt covenants and certain key performance indicators (KPIs).Putting operating leases on the balance sheet increases the transparency of financialstatements with regard to a company’s financial obligations (aka liabilities), as wellas the property and equipment (aka assets) needed for company operations.

The benefit of transparency comes at a cost for lessees, especially those with operatingleases. Lessees must begin complying with the new standards by taking an inventory of alltheir operating leases, which can be a major administrative undertaking. Then they mustcomplete numerous — and complicated — accounting calculations. Changes to therules were less dramatic for capital leases, though these are now called finance leases. Thestandards for lessors were largely unchanged.

The lease accounting standards that capture these changes are:

• ASC 842: This standard is from the FASB, which sets the rules for USGenerally Accepted Accounting Principles (GAAP). ASC 842 establishes the threeclassifications of leases for lessors (sales-type, financing and operating) and thetwo classifications for lessees (financing and operating). It also prescribes thedual accounting treatment described above. The goal of ASC 842 is to better accountfor leases that are, in effect, purchases. This standard went into effect for publiccompanies in 2019 and becomes effective for private companies after December 15,2021.

• GASB 87: A kind of sister organization to the FASB, the GASB definesGAAP rules for state and local governments (federal government GAAP rules come fromthe Federal Accounting Standards Advisory Board, or FASAB). GASB 87 updated leaseaccounting standards for its constituents with a single treatment approach for allleases that is similar to the IFRS 16 approach. GASB 87 became effective on June 15,2021.

• IFRS 16: The IASB, which sets international financial reportingstandards, issued IFRS 16. It specifies a single accounting treatment for all leasesthat is similar to the way financing leases are handled in ASC 842. IFRS 16 isfollowed in jurisdictions around the world, and US companies with parents orsubsidiaries abroad need to be aware of the differences between IFRS and GAAP. Thisstandard became effective January 1, 2019.

In summary, the three standards are mostly consistent regarding lease definitions and variousterminology. However, ASC 842 takes a dual approach to accounting treatment, while IFRS 16and GASB 87 both use a single approach. There are other inconsistencies that a trained leaseaccountant can advise on, such as how to reflect leases on cash flow statements, how andwhen to revalue a lease for material changes in lease terms or impairment, and which fiscalperiods on comparative financial statements may need to be restated. Conveniently, all threestandards provide exemptions for short-term leases — those shorter than 12 months.

Leasing Advantages

Leases are common because they provide many advantages to businesses. Lessees often think ofleases as a “best of both worlds” scenario, where they get to use and controlassets theyneed to run their business without the hassle and risk of ownership. Specifically, someadvantages of leases are:

• Higher purchasing power: Leases typically require lower upfrontcosts than purchasing property outright. So, leases leave more money in thebusiness’s pocket for other expenses. Upgrades to newer or better equipmentare also easier under a lease, compared to purchases.

• Lower long-term maintenance costs: Lessees perform maintenance onleased assets only during the lease term. Carefully structuring the length of alease relative to the life of an asset can avoid more costly upkeep for olderassets.

• Better cash flow management: Negotiating leases with flexiblepayment schemes — think: no money down, accelerating/decelerating payments orballoon payments — can improve a business’s cash flow. Once paymentterms are set, the business can more reliably forecast its cash requirements.

• Simplified asset disposal: Lessees typically return the asset to thelessor when the lease term is complete, though a finance lease transfers assetownership to the lessee. This is especially advantageous for businesses that need anasset only for a particular period, like certain heavy equipment needed for amultiyear construction project, and for assets that become obsolete quickly, such ascomputers.

Leasing Disadvantages

On the other hand, leases also can have significant disadvantages for a business, such as:

• Interest: Lease payments include an interest charge, an avoidableextra cost compared to outright purchasing with cash.

• Lost tax deductions: Businesses that purchase assets can claimdepreciation to reduce taxable income. These deductions may be lost under certainleases. It’s important to consult a tax accountant for your specific situationand jurisdiction, especially given the new lease standards.

• Lost residual value: The flip side to easy asset disposal at the endof an operating lease is that most times the lessee doesn’t own anything aftermaking all the lease payments. Any salvage, or residual, value reverts back to thelessor.

• Lease administration: Accounting for leases has become moreburdensome because of the new standards. Some industry estimates suggest thatprivate companies may need a full year to make the necessary adjustments to comply.

6 Lease Accounting Steps

For a typical business, there are six steps in accounting for a new lease.

1. Determine if a lease exists: Analyze the transaction to identifywhether a lease, or multiple leases, exists in accordance with the new leasestandards. Each lease needs to be accounted for individually. Important exceptionsare leases of intangible assets, inventory, assets under construction, biologicalassets and assets related to certain environmental explorations (e.g., oil and gasassets), all of which are covered by other standards.

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2. Remove non-lease components: Any non-lease components involved inthe transaction should be removed from the lease value. For example, a leasecontract for office space may also include perks such as free employee parking orlandlord-paid improvements. This step requires estimates or appraisals to determinethe value of the perks so that a portion of the total “lease” paymentscan beallocated to such non-lease components.

3. Classify the lease: Classify the lease using the five criteriadefined in the standards, enumerated under the section “Lease AccountingExplained”.

4. Measure the lease’s present value: For most leases with a termof 12 months or more, the lessee calculates the present value of the lease paymentsusing either the lessor’s implicit interest rate or the lessee’sincremental borrowing rate. Present value is a financial concept that considers thetime value of money, using certain assumed interest rates. Simply stated, presentvalue recognizes that today’s dollars are worth more than future dollars, andso translates future cash inflows into today’s dollars. Incremental borrowingrate, commonly used for lease present value measurement, is the rate at which alessee could borrow a similar amount from their lending institution. Themeasurements establish the value of the right-of-use asset and the related leaseliability.

5. Determine amortization: Based on the lease classification, the assetis systematically reduced using either a straight-line approach (reduced by the sameamount each year, over the duration of the lease) or the effective interest method(an accelerated approach that yields more amortization sooner).

6. Create journal entries: Using the appropriate accounting treatmentfor the lease category, create journal entries to record the initial lease and allrecurring entries throughout the lease duration. Lease accounting should be part ofevery fiscal close.

The following graphic summarizes and compares key aspects involved in lease accounting, underthe new GAAP standards.

Lease Accounting Example

Since operating leases for lessees are the most effected by the new guidance, here’s anexample to Illustrate how a typical three-year operating lease would be accounted for in aseries of journal entries over the life of a lease. Consider ABC Inc.’s lease of amachine from XYZ Inc., the lessor.

ABC leased a machine from XYZ for three years for $2,500 per month, a total of $90,000. UsingABC’s 6% incremental borrowing rate, the PV of ABC’s rental payments is $82,588.Since the PV of the lease is significantly less than the machine’s fair market value($100,000), the lease is categorized as an operating lease. Under ASC 842, ABC reports themachine as a right-of-use asset with a corresponding lease liability on its balance sheet.

Together, these two journal entries add a total of $30,000 amortization expense toABC’s income statement. Additionally, the right-of-use lease asset was written down tozero since the asset was returned to the lessor. Similarly, the machine lease obligation isalso fully written off, reflecting the satisfaction of the lease payments.

Improve Lease Accounting With Software

The new accounting standards for leases dramatically change the accounting burden, especiallyfor lessees, by forcing adoption of new business processes, internal controls and systemrequirements. Experiences from international companies and public companies that are alreadycomplying with IFRS 16 and ASC 842 show that most were inadequately prepared and/or theirtechnology solutions took more time than expected to implement. Using manual spreadsheetsmay be a viable option only for the smallest and least active private businesses. Leaseaccounting software, such as that included in NetSuite Fixed AssetsManagement, captures key lease details, reflects payments, generates amortizationschedules and records journal entries for every account affected by the lease, over theduration of the lease, in a secure environment.

Conclusion

Determining whether leasing is right for your business requires thoughtful consideration ofmany variables. The new accounting standards challenge conventional wisdom and createsignificant lease accounting burdens. Using the right automated lease accounting softwarecan help clear away those burdens and allow business leaders to make better-informeddecisions by staying focused on the unique pros and cons of leasing for their business.

Lease Accounting FAQs

What is ASC 842 lease accounting?

ASC 842 is a standard from the Financial Accounting Standards Board (FASB) that establishesthe three classifications of leases for lessors (sales-type, financing and operating) andthe two classifications for lessees (financing and operating). It also prescribes differentaccounting treatments depending on the classification. The goal of ASC 842 is to betteraccount for leases that are, in effect, purchases. This standard went into effect for publiccompanies in 2019 and becomes effective for private companies after December 15, 2021.

How do you record a lease in accounting?

There are six steps to recording a lease in accounting. First, determine if a lease exists.Second, remove non-lease components. Third, classify the lease using the five criteriaincluded in ASC 842. Fourth, measure the lease. Fifth, determine the amortization method andgenerate an amortization schedule. Sixth, create journal entries using the appropriateaccounting treatment for the lease category.

What is the new lease accounting standard?

New lease accounting standards aim to eliminate “off balance sheet” treatment ofoperatingleases. The lease accounting standards are ASC 842 (FASB), IFRS 16 (IASB) and GASB 87(GASB). ASC 842 takes a dual approach to accounting treatment depending on the type oflease, while IFRS 16 and GASB 87 both use a single approach.

What is the accounting treatment for leases?

The first step in selecting the appropriate lease accounting treatment is determining theclassification of the lease, using certain tests included in accounting standards. Once thedesignation is determined, the lessor makes certain journal entries and disclosures, and thelessee makes others. Lessors classify leases as: sales-type leases, direct financing leasesor operating leases. Lessors de-recognize the underlying asset (i.e., remove the actualasset from their balance sheets), recognize any profit or loss on the asset, and establishan investment in the lease that “replaces” the asset. Over the duration of asales-typelease, the lessor records interest income and reduces the balance of the lease investment ascash payments are received. Lessor accounting for direct financing leases is similar butdefers any profit/loss on the asset. For operating leases, which are the least sales-like,lessors retain the asset and related depreciation on their books and simply record interestincome.

Lessees can classify leases as either an operating lease or a finance lease, based on certaintests included in the standards. In the case of finance leases, where the relationship ismore like ownership, lessees record the right-to-use asset and a lease liability on theirbalance sheet. Each time a lessee makes a payment, they amortize the asset, reduce the leaseliability and recognize interest expense on the income statement. In an operating lease,which is more like a rental than ownership, the new rules require the lessee to followsimilar steps for recording the right-of-use asset and a lease liability on its balancesheet, but the expense is reflected as amortization expense in the operating section on theincome statement.

What are the accounting rules for a lessor?

Lessors classify leases as sales-type leases, direct financing leases or operating leases. Insale-type and direct financing leases, lessors de-recognize the underlying asset, recognizeany profit or loss on the asset and establish an investment in the lease. Over the durationof a sales-type lease, the lessor records interest income and reduces the balance of thelease investment as they receive cash payments. The lessor accounting for a direct financinglease, which is less like an outright sale, defers any profit/loss on the asset. And foroperating leases, which are the least sales-like, lessors retain the asset and relateddepreciation on their books and simply record interest income.

What are lessor account statements?

The accounts used by lessors differ, depending on the category of lease. Lessors classifyleases as sales-type leases, direct financing leases or operating leases. Sales-type leasesand financing leases impact both balance sheet and income statement accounts for lessors.Operating leases impact only a lessor’s income statement accounts.

How is a financing-related lease accounted for by lessor and lessee?

Lessors account for direct-financing leases by recognizing an investment in the lease, anyinterest revenue and derecognizing the underlying asset. During the lease, the leaseinvestment increases for any interest income and declines as lease payments are received.Any selling profit or initial direct costs are deferred, but losses are recorded at theinception of the financing lease.

Under a finance lease, a lessee records the right-of-use asset and amortizes it over the lifeof the lease. The lessee also records a lease liability. As lease payments are made, aportion of each payment reduces the lease liability and the rest increases interest expense.