What is lease accounting?

Lease accounting is the process by which entities record the financial impact of agreements to rent or finance the rights to use specific assets. This is commonly known as leasing. Recent accounting pronouncements have changed the way lessees and lessors are required to account for and report their leases.

The reporting standards for lease accounting are maintained by the Financial Accounting Standards Board (FASB) in the United States, International Accounting Standards Board (IASB) internationally, and the Governmental Accounting Standards Board (GASB) for state and local entities in the United States.

Lessee vs. lessor

The terms “lessee” and “lessor” are used to identify the different parties involved in a lease agreement. This distinction is important because lease accounting as a lessor is significantly different from lease accounting as a lessee. When the various accounting boards for the domestic, international, and government entities issued new lease accounting standards, the underlying definitions of lessor and lessee did not change. However, some of the accounting treatment for lessors and lessees under the new lease standards did change.

Lessee definition

A lessee is defined as the entity paying for the use of specific property from a lessor. For example, if a person leases a vehicle from a car dealership, the person using the car is the lessee. Conceptually, the lessee is paying the lessor for the “right to use” the asset. This is why the lessee, per the new lease standards, is required to recognize an intangible “right-of-use asset” (ROU asset) or a “lease asset” when accounting for the lease. It is important to note this asset is classified as an intangible asset on the lessee’s books, rather than a fixed asset.

Lessor definition

A lessor is defined as an entity (i.e. a person, company, or organization) providing the right to use an asset for a period of time in exchange for consideration. One of the more common scenarios of a lease agreement is an entity renting their owned property to another entity for a monthly cash payment. For example, if an organization owns a building and leases the right to use the building or space within the building, the owner of the building is the lessor, also commonly referred to as the landlord.

Lease accounting under the old standards

The legacy lease accounting standards included ASC 840, IAS 17, and various GASB standards, mainly GASB 13 and GASB 62. Before the announcement of new lease accounting standard requirements, most companies did not find it essential to pay close attention to operating leases within the financial reporting process. This was because lessees with operating leases would only recognize an expense over the lease term with limited balance sheet impact.

The most complex accounting for leases under the old standards was for capital leases, known as finance leases under IAS 17 because the old standards required these leases to be recorded on the balance sheet. The capitalized assets and liabilities related to capital/finance leases were recognized on financial statements and amortized over a specific period.

New lease accounting standards, changes, and full examples

The FASB, IASB, and GASB have released new lease accounting standards over the last several years, which are ASC 842, IFRS 16, and GASB 87, respectively.

Initially, the FASB worked in conjunction with the International Accounting Standards Board (IASB) to develop their new standards. The GASB developed its standards independently and there are some notable differences.

All companies that lease assets are affected by the new standards. Some considerations exist within each standard to omit specific types of transactions from capitalization (i.e. short-term leases). However, all companies with the right to use at least one in-scope asset qualifying as a lease will need to apply the new standard.

The primary change to lease accounting under the new standards is that organizations must now recognize lease assets and lease liabilities on the balance sheet for most of their lease arrangements. Lessees are required to calculate the present value of future lease payments to establish a lease liability and the related ROU asset.

The lessor accounting differs depending on the standard. For GASB specifically, lessors will mirror the accounting on the lessee side, recognizing a lease receivable and deferred inflow of resources.

Other changes include

• Lease classification
• The definition of a lease
• How initial direct costs (IDC) are defined
• More extensive disclosure requirements
• The treatment of lease and non-lease components

Below are summaries of lessee and lessor accounting under ASC 842, IFRS 16, and GASB 87.

ASC 842

Under ASC 842, the new lease accounting standard for US companies following US GAAP, lessees are required to recognize lease assets and lease liabilities on their balance sheets for both operating and finance (previously capital) leases. The lessee is required to perform a present value calculation of future expected lease payments to establish the lease liability and the related ROU asset. Accounting for leases classified as operating leases is affected the most, as leases classified as capital leases were already recognized on the balance sheet under ASC 840. ASC 842 is effective for nonpublic entities for fiscal years beginning after December 15, 2021, and December 15, 2019, for publicly-traded companies.

The accounting for the lessor is largely unchanged from ASC 840 to ASC 842. Lessors continue to recognize lease income for their leases, and balance sheet recognition requirements stay predominantly the same. The lease agreement’s underlying asset will continue to be classified as the lessor’s fixed asset.

Under ASC 842, there are three types of lessor leases:

• Direct Financing – lessors are required to establish a lease receivable and interest income
• Sales Type – lessors are required to establish a lease receivable and interest income. The difference between direct financing and sales-type leases is revenue (With a sales type, the lessee has control of the underlying asset and the lessor recognizes sales revenue and profit at lease commencement)
• Operating – lessors recognize income on a straight-line basis

Lessees and lessors have the option to elect a package of practical expedients to aid in the adoption of the new standard, in which the lessor is not required to reassess lease classification. Therefore, we expect many lessors to elect this expedient and retain previously established lease classifications when transitioning from ASC 840 to ASC 842.

IFRS 16

IFRS 16 is the new international lease accounting standard. This pronouncement also requires lessees to recognize a lease liability calculated as the present value of the expected lease payments and a related ROU asset. An additional change in the IFRS guidance is that all leases will be classified as finance leases, which differs from US GAAP. This single model approach eliminates the operating lease classification for lessees under IFRS. The standard’s effective date was January 1, 2019.

While the lessee model for IFRS 16 is a single model approach, for lessors the operating and finance classification model continues. Lessors are required to determine if a lease is classified as an operating or finance lease and use the appropriate accounting treatment.

The main driver between operating and finance leases for lessors under IFRS 16 is transfer of ownership. Lease agreements where the lessor maintains ownership are operating leases. For operating leases, the lessor continues depreciating the leased asset and records the incoming lease receipts as revenue on a straight-line basis over the lease term.

When the lease agreement is classified as a finance lease, the lessor will calculate the net investment in the lease using the present value of future expected lease receipts and record this amount as a receivable. Lessors are also required to derecognize the carrying value of the underlying asset. Any difference between the net investment in the lease and the carrying value of the underlying asset is recognized as a gain or loss on the income statement.

GASB 87

Government entities reporting under GASB 87 recognize a lease liability and related lease asset at the commencement date of the lease. The lease liability is equal to the present value of the expected lease payments over the lease term and the related lease asset is equal to the lease liability with a few minor adjustments. GASB 87 is effective for fiscal years beginning after June 15, 2021.

Like IFRS 16, GASB 87 also uses a single model approach, in which all leases are classified as finance leases. Under the new standard, recognizing a lease liability and lease asset for all leases formerly classified as operating is a significant change.

Lessors under GASB 87 record a lease receivable and a deferred inflow of resources at the commencement of the lease term. As with the lease liability for a lessee, the lease receivable is calculated as the present value of the lease receipts expected during the lease term. The deferred inflow of resources is equal to the lease receivable with a few minor adjustments and is similar to deferred revenue.

The GASB intended for lessor accounting to effectively mirror lessee accounting under the new lease accounting standard. This is accomplished by the lessee and the lessor recognizing the present value of the expected remaining lease payments or receipts, respectively, offset by the corresponding ROU asset and deferred inflow of resources.

Why were these changes implemented?

The impetus behind the standard changes was to enhance transparency into financial obligations. Leases have long been a blind spot for financial statement users. Each of the standards requires entities to bring most leases onto the balance sheet.

After the financial scandals of the early 2000s, regulators and legislators issued numerous regulations and laws to reduce corporate fraud; however, lease obligations remained opaque. During The Great Recession of 2008, several firms with major leasing liabilities went bankrupt, despite a balance sheet that appeared clean. With operating lease liabilities not recognized on the balance sheet, investors did not have a full picture of a company’s obligations.

Here are some ways that the new standards will improve financial reporting:

• Offers fewer opportunities for organizations to manipulate lease transactions to avoid recognition on the balance sheet
• Provides a more comprehensive insight into a lessee’s obligations
• Reduces the need for stakeholders to compensate for the lack of financial visibility by adjusting the recognized liabilities on the financial statements
• Aligns lessor accounting and guidelines for sale-leaseback transactions with the comparable 2014 revenue recognition standard, ASC 606
• Exposes lessors’ credit and asset risk as a result of leasing
• Clarifies the definition of a lease and how to specifically identify an embedded lease asset within a contract

Lease accounting calculations you need to know

Before you begin preparing your financial reports, you need to get a deeper understanding of what the standards require. There is a complex set of calculations you have to complete to be fully compliant. Below are some calculations that are necessary to account for your leases under the new standards and successfully navigate your transition:

Present value of future lease payments

Present value is the calculation of what a future sum of money or stream of cash flows is worth today given a specified rate of return over a specified period. Under the new lease accounting standards, lessees are required to calculate the present value of any future lease payments to determine the obligations to be recorded on the balance sheet for both operating and finance leases. The calculation is performed using the term and payments specified in the lease and a rate of return that is specific to either the lease or the organization. The present value of the lease payments is used to establish both a lease liability and a right-of-use asset.

Lease amortization schedule

The lease liability is the present value of the future lease payments and is recorded alongside the right-of-use asset for operating and finance leases. Under ASC 842, the lease liability is not considered debt. Under IFRS 16 and GASB 87, however, a lease liability is considered long-term debt. It’s important to know how to properly calculate the lease liability amortization schedule whether you plan to use Excel or lease accounting software. The more you know, the better you’re able to ensure that the calculation is accurate.

Right-of-use asset

The right-of-use asset, or ROU asset, is the value of the lessee’s right to control the use of a specific asset over a specific period. Under ASC 842, the ROU asset is calculated as the lease liability amount and any lease prepayments plus any direct costs, less any lease incentives. ROU assets and lease liabilities are presented separately on the balance sheet.

Straight-line rent expense

The concept of straight-line rent expense requires lessees to charge their total lease liability to expense on an even, periodic basis over the lifetime of the contract. Similar to straight-line depreciation, this method is required to evenly recognize a fixed asset over its useful life. Similarly, straight-line rent expense is calculated by aggregating all rent payments and dividing them by the full contract term.

Discount rate or interest rate

When it comes to ASC 842, IFRS 16, or GASB 87 determining the right discount rate or interest rate can be tough. The rate implicit in the lease is the most appropriate discount rate to use for your lease calculations. If you’re unsure about the implicit rate after combing through the lease, there are ways to determine the rate on your own. First, determine the fair value of the asset at the beginning and end of the lease, and what your payments are. Then, use that information to conduct a present value calculation. If you don’t know or are unsure about the fair value of the asset, you would then use the incremental borrowing rate. Under ASC 842 If you’re a private company and cannot find any of the rates above, you can also use the risk-free rate.

In addition to the calculations outlined above, you’ll also need to consider the liability reduction, asset lease expense, weighted average discount rates for operating and finance leases (under ASC 842), and the weighted average lease term for finance and operating leases (under ASC 842).

Beyond these items, you’ll need to consider the necessary disclosures that use these calculations but report on them in different ways.

Challenges companies face under the new standards

As companies adopt the new standards, they need to record all leases on the balance sheet, which, for public companies, has resulted in an average liability increase of 1,475%.

Transitioning is a monumental task, in correlation with the significant change to the face of the financials. While transitioning is often successful, the road to adoption is challenging.

• Job loss and damaged reputation for senior leaders
• Loss of stakeholder confidence
• Loss of funds or available funding
• SEC scrunity
• Increase in audit costs

Individuals need to push back against these hurdles to ensure compliance holds top priority.

Why embedded leases are a particular challenge

One of the biggest challenges entities face when compiling their lease portfolio involves identifying their embedded leases. A typical real estate lease can require legwork to gather the appropriate data, but the process of identifying the lease itself does not provide immense difficulty.

Embedded leases, which refer to leased assets provided within service, outsourcing, and maintenance contracts, may require additional work to discover. Examples of contracts that can contain embedded leases include

• Warehousing contracts – although typically outsourced, these agreements may contain language that meets the definition of a lease.
• Security contracts – these types of services may also contain access to scanners or equipment, which could qualify as a lease under the standard’s definition.
• Transportation contracts – depending on the terms, the vehicles used for transport could qualify as a lease asset
• Data storage contracts – much like security contracts, these agreements could include embedded leases for both the servers or the space the servers occupy.

Departments responsible for procurement will not typically have a comprehensive understanding to know whether the contract includes any assets that qualify as an embedded lease. The process of dissecting each contract for embedded lease assets might just earn the title of the most daunting exercise that the lease accounting transition requires.

Lease accounting software: Why is there a sudden need for it?

Excel and accounting go hand in hand. Excel offers the ability to achieve nearly any result desired – or so many think. However, for compliance with the new leasing standards, Excel simply won’t cut it. Too many opportunities exist to make mistakes.

Excel has limitations when considering the complexity of the new standards. For example, when considering the practical expedients offered by the boards, Excel does not offer the capabilities of building those elections into a spreadsheet. This is one of the reasons why audit firms suggest using software for compliance.

Additionally, software provides the ability to house all leases within a central repository and provides access across an entire organization, rather than only to contract owners. Ideally, this central repository will provide access to the document, amortization schedules, critical date alerts, journal entries, and footnote disclosures all at once.

To address the complexity of the new standards, companies must look to software built specifically for lease accounting. The software should address the accounting, reporting, and document management needs your company, auditors, and regulators require.

Considering the judgmental nature of these new standards, companies should ensure they have lease accounting experts at their disposal to assist in navigating the complexities and nuances of the standards.

Choosing the right solution

Implementing a lease accounting solution should not happen overnight. When comparing solutions, companies should consider:

• Whether the software supports its internal controls
• Whether the provider completes a system and organizational controls audit of both design and operating effectiveness
• User reviews – and what specific role the reviewer has within their organization

While budget constraints may make pricing an initial decision factor, evaluating on price alone will only lead to costly headaches in the long run.

The same goes for choosing to use lease management software that was not originally architected for accounting compliance. Many lease management companies have added accounting modules to their software. However, those programs often include shortcomings, as the product teams usually lack the expert guidance of lease accountants.

The hidden benefits of the new accounting standards

One silver lining of implementing the new standards is departments in your organization will begin working together more seamlessly to manage and account for leases. Transitioning to the new standards provides an opportunity to integrate processes and tools so all stakeholders have the same understanding of lease agreements and how the contracts affect the business.

Many public companies that have already implemented lease accounting solutions have found their facilities, procurement, and other leasing departments now provide more complete data when entering into new contracts. This results in fewer accounting hours spent gathering information and more time devoted to achieving core business goals.

Even further, compliance with the new standards provides exactly what the FASB, IASB, and GASB are designed to ensure: financial comparability and transparency amongst organizations across all industries and sizes!