Leasing is a common practice in the business world, with companies often opting to lease assets rather than purchasing them outright. While leasing can offer several advantages, such as flexibility and cost savings, it also requires careful accounting to ensure accurate financial reporting.
With the introduction of new lease accounting standards, it’s more important than ever for businesses to understand lease accounting clearly.
Whether you’re a lessee or lessor, understanding these concepts will help ensure your financial statements accurately reflect your lease transactions.
1. Definition of a Lease
A lease is a contractual agreement between a lessee and a lessor that grants the former permission to use an asset for a specified period in exchange for payments.
The asset in question could be anything from property, machinery, vehicles, or software. The lease agreement outlines the terms and conditions under which the lessee can use the asset, such as the duration of the lease, the amount and frequency of payments, and any other relevant provisions.
It’s important to note that a lease differs from an outright purchase. In a purchase, the buyer becomes the asset’s owner, whereas in a lease, the lessor retains ownership, and the lessee only has permission to use the asset.
2. New Lease Accounting Standards
The new lease accounting standards, such as ASC 842, were implemented in 2019 by the Financial Accounting Standards Board (FASB) to improve transparency and accuracy in lease reporting. Under these standards, companies must disclose their lease obligations, including future lease payments, on their financial statements.
Understanding the new lease accounting standards is essential for investors, analysts, and anyone involved in financial reporting to better evaluate a company’s financial health. Review the complete standard and consult with a certified public accountant to learn more about ASC 842 for guidance on implementation.
3. Two Types of Leases
Regarding lease accounting, it’s important to understand the two main types of leases: operating and finance.
4. Lease Term
The lease term determines the period during which the lessee has the right to use the leased asset and is responsible for making lease payments. It includes the initial non-cancellable lease term and any periods for which the lessee can extend the lease. The lease term also includes any periods for which the lessee can terminate the lease if the lessee is reasonably certain they do not want to continue with the lease.
5. Lease Payments
Lease payments represent the lessee’s consideration to the lessor for the ability to use an asset during the lease term. Lease payments can include fixed payments, variable payments, and any payments related to the termination of the lease.
6. Right-Of-Use Asset
Right-of-use asset represents the asset the lessee is permitted to use during the lease term. It is recognized on the balance sheet. The right-of-use asset amortizes over the lease term, and the corresponding lease liability reduces as lease payments are made.
This asset is crucial for lessees as it allows them to accurately reflect the economic reality of their lease arrangements, which helps investors and other stakeholders make better-informed decisions.
7. Lease Liability
Lease liability represents the lessee’s obligation to make lease payments to the lessor during the lease term. The lease liability is measured at the present value of the lease payments, which includes the fixed and variable lease payments and any payments related to the termination of the lease. The lease liability is then adjusted over time to reflect any changes in lease payments or lease terms.
The new lease accounting standards require lessees to recognize lease liabilities for all leases with terms greater than 12 months, which can have significant implications for a company’s financial statements and financial ratios.
8. Initial Direct Costs
These costs are incurred by the lessee and are directly related to negotiating and arranging a lease, such as legal fees, commissions, and other costs associated with obtaining the lease. Under the new lease accounting standards, initial direct costs are included in the measurement of the right-of-use asset and are amortized over the lease term.
Lessees must adequately identify and allocate these costs to ensure accurate lease accounting and financial reporting. Failure to do so could result in an overstatement or understatement of lease assets and liabilities, which may impact the economic health and performance of the company.
Disclosures require lessees and lessors to provide additional information in their financial statements related to their leases. These disclosures include details about the nature and terms of the leases, the amounts recognized in the financial statements, and any significant judgments and assumptions made in applying the lease accounting standards.
Additionally, lessees must provide information on their future lease payments, which can help stakeholders better understand the lessee’s financial position and potential future cash flows.
Understanding lease accounting can be a challenging task for both lessors and lessees. It involves knowing the proper accounting standards, identifying lease terms and payments, and determining lease classification.
However, with the help of modern lease accounting software, this task has become much more manageable, efficient, and less prone to errors.
Knowing the key concepts and requirements of lease accounting can help you make informed decisions and stay compliant with the relevant accounting standards, whether you are a lessor or a lessee.
By visiting up-to-date lease accounting regulations and leveraging modern technology, you can streamline your lease management process, improve accuracy and reduce risk. Moreover, don’t hesitate to seek help from professionals in lease accounting to ensure you stay on top of your company’s finances.