Everything You Need To Know About Accounting For Leasing

November 26, 2022
Alok Suman
Lease Management

Leasing property or assets against a fixed amount of money is a common practice for businesses. There are multiple advantages of leasing, including an increase in the business's purchasing power, low maintenance costs, and better cash flow management. 

Any lease agreement requires two parties in order to exist. One party here leases their asset to the other, and a contractual agreement is signed as a lease outlining all details of the asset loan. 

One of these parties is known as the lessor, and the other is called the lessee. But who exactly are the lessor and lessee? What are the differences between the two?

What is accounting for leasing? How do financial statements differ for the lessor and the lessee? And why is it best to use software to adhere to lessor/lessee accounting? 

Let's understand these in detail. 

What is a Lease?

A lease refers to a contract between two different parties for the temporary use of an asset in return for a fixed payment. Every lease is backed by a lease contract that documents key terms for each lease and is signed by the lessor and the lessee.

The parties involved here are the lessor (property or asset owner) that allows another party (the lessee or borrower) to use an identified property, piece of equipment, or plant for a defined period of time in exchange for compensation.

The two most common types of leases for lessees include operating leases and finance leases. Different businesses use different types of leases, tailoring them to include various details specific to each lease agreement.

New Lease Accounting Standards

There are three new accounting standards in recent times, which are discussed below:

  • IFRS 16

IFRS 16 is a leasing standard issued by the International Accounting Standards Board (IASB) in January 2016, and the same went into effect on January 1, 2019.

  • ASC 842

ASC 842 is the latest FASB lease accounting standard that all public companies/businesses were required to adopt in 2019, and private companies were required to adopt in 2020. 

  • GASB 87

GASB Statement No. 87, or GASB 87, is the latest lease accounting standard issued by the Government Accounting Standards Board (GASB) for governmental organizations. The standard requires your organization to develop various policies and controls to facilitate adoption as soon as possible.

Advantages of Leasing 

A lease is generally a more attractive option as compared to a loan or a purchase contract. There are several distinct advantages of leasing, including the following:

  • Lower after-tax costs due to differing tax rates for both lessors and lessees.  
  • Leasing lets businesses access properties or assets without spending too much on the purchase of assets.
  • 100% financing of the price of the asset.  
  • Once the lease term ends, the lessee can return the leased equipment to the lessor, and the same can be replaced through a fresh lease agreement. 
  • Scheduled payments that are more flexible as compared to the payments under loan contracts.  

Disadvantages of Leasing

Apart from several benefits, there can also be some disadvantages to leasing. Among these are:

Agency cost issues

  • The separation between the asset’s ownership (lessor) and control of the asset (lessee).
  • In a lease, all rights are transferred by the lessor to the lessee for a defined period of time.
  • Since the lessee here is not the owner, the lessee (in some cases) may not care for the assets as their own.
  • This kind of separation between the asset’s ownership and control of the asset is known as the agency cost of leasing.

Various issues with lessees

  • For example, tax considerations, bad debts, delayed payments, and more.

 What is a Lessor?

A lessor is someone who grants the permission or use of an asset to someone else. In a lease agreement, the lessor is the owner of the asset or property under the agreement.

Other Key Highlights 

  • The lessor enjoys the sole ability to grant special privileges to the lessee. Among these include renewal on unchanged terms or early termination of the lease.
  • The key advantage of being a lessor is that in granting the other party the ability to use your asset or property, you get a return on your investment without giving up ownership.

What is a Lessee?

A lessee, on the contrary, is someone who either has to make a one-time payment or a series of periodic payments to the lessor in exchange for using their property. The lessee has no ownership of the asset but only enjoys the ability to utilize the asset temporarily.

Other Key Highlights 

  • The lessee is fully responsible for taking care of the asset and conducting regular maintenance, as necessary, during the period of the lease.
  • If the lease is on an apartment, the lessee is not allowed to make any structural changes without the due permission of the lessor. Any kind of damage to the apartment or property must be repaired by the lessee before the expiry of the contract. 

Lessor vs. Lessee - Key Differences

The terms lessor and lessee are used to refer to the different parties involved in a lease agreement. It is important to differentiate between the two because the lease accounting for a lessor is significantly different from that of a lessee.

The other key differences between the two are as below:

Differences Lessor Lessee
Meaning The lessor in a lease agreement is the owner and has the right to transfer the asset to the lessee for a lease. The lessee, on the contrary, is the temporary owner, who takes possession of the property or asset for an agreed price.
Status The lessor is the legal owner of the asset. The lessee is simply a borrower and does not enjoy the status of a legal owner of the asset.
Compensation The lessor gets the total amount of the lease in return. The lessee gets the asset or property for temporary use and pays the lease.
Asset possession The lessor does not possess the asset. Lessees possess the asset or property.
Taxation The lessor has to pay taxes against the property or income. Since the lessee only temporarily holds the asset, they do not have to pay the taxes.
Restrictions There is no restriction on property usage. However, they need to have permission when the property is under-lease. The lessee usually has restrictive control over the property or the asset.
Bankruptcy In case the lessee goes bankrupt, the lessor enjoys the right to get the payments first. The lessee has no relation if the lessor gets bankrupt since they do not owe the lessee any money.
Termination The lessor enjoys the right to terminate the contract in case any damage is done to their property by the lessee, or the lessee fails to follow any clause of the contract. The lessee can terminate the contract only in case of an unexpected event, such as a flood or fire.

What is Lease Accounting?

Lease accounting refers to the process used by companies to record the financial impact of their leases. Most entities are now required to record the majority of their leases on the balance sheet following the release of the new lease accounting standards.

To understand it better, let's look at each financial statement:

  • Balance sheets- These sheets typically help a company track its assets and liabilities and must always be balanced.
  • Income statements- Income statements of any organization help track its income and expenses over time.
  • Cash flow statements- Cash flow statements of a company typically reflect the transfer of money into and out of business during a defined period.

It's important to note that how a lease is recorded on each of these financial statements would depend on whether you're a lessor or the lessee.

When recorded accurately, these financial documents can offer a transparent picture of the overall value of a company’s assets and, in turn, its overall financial health.

Further,  accounting standards from several well-known organizations, including the Financial Accounting Standards Board (FASB), International Accounting Standards Board (IASB), and Government Accounting Standards Board (GASB) in the U.S., govern how these leases are classified for accounting purposes.

What is the Aim of Lease Accounting?

The key aim of accounting for leasing is to clearly and transparently reflect the true nature of the underlying lease agreement for some of the key considerations. These include:

  • Recording and valuing the property or asset at inception as that value changes throughout the lease duration.
  • Recognition of lease liability on a lessee’s balance sheet clearly and transparently.
  • Proper recognition of various income statement aspects such as lease revenue, expenses,  profits, and losses on leased assets.

Lease Accounting Calculations You Need to Know 

Below are some of the calculations that are quite necessary to account for your leases under the new leasing standards and navigate your transition successfully:

a. Present value of future lease payments

The present value of lease payment is simply the calculation of what a future sum of money of cash flows is worth today, given a specified rate of return over a specified period.

The new lease accounting standards mandate that lessees calculate the present value of any future lease payments in order to determine the obligations to be recorded on the balance sheet for both operating and finance leases. 

b. Lease amortization schedule

The lease liability is essentially the present value of all future lease payments and is typically recorded along the right-of-use asset for operating and finance leases.

Knowing how to properly calculate the lease liability amortization schedule is essential, as the more you know, the better you will be able to ensure your lease calculations are accurate.

c. Right-of-use asset

The right-of-use asset is the value of the lessee’s right to control the use of a specific property or an asset over a specific period.

Under ASC 842, the right-of-use-asset asset is calculated as the lease liability amount and any lease prepayments, along with any direct costs, minus any lease incentives.

d. Discount rate or interest rate

The most appropriate discount rate to use for your lease calculations is the rate implicit in the lease. If you’re not sure about the implicit rate, there are different ways to determine the rate on your own.

For instance, you can determine the fair value of the asset at the start and end of the lease, along with your payments. You can then use that information to conduct a present value calculation. 

Understanding Lessee vs. Lessor Accounting

Lease accounting varies for lessors and lessees. In this section, we will see how the two differ:

a. Lease accounting for lessees

At the beginning of a lease, the lessee is required to measure a lease’s:

  • Lease liability: Lease liability refers to the present value of lease payments, including any discount rates.  
  • Right-of-use asset: Right-of-use asset is the initial amount of any lease liability, which takes into consideration any lease payments made before the commencement date  

It is also important to remember that when a lessee has designated a lease as a finance lease, it should recognize:  

  • The ongoing amortization of the right-of-use asset 
  • Any variable lease payments that are not part of  the lease liability
  • The ongoing amortization of the interest on the lease liability

On the contrary, when a lessee has designated a lease as an operating lease, the lessee should recognize:  

  • Any kind of variable lease payments that are not included in the lease liability 
  • A lease cost in each period, where the total cost of the lease is allocated over the lease term on a straight-line basis.

b. Lease accounting for lessors 

Under accounting standard IFRS 16, the lessor puts each lease in either the category of operating lease or finance lease.

Whereas under accounting standard ASC 842, the lessor put leases under the below categories:

  • Sales type lease
  • Operating lease 
  • Direct finance lease

If a lease agreement meets any of the below conditions, it is classified as a finance lease (IFRS 16) or a sales-type lease (ASC 842):

  • Both the current value of the lease and guaranteed residual is either equal to or more than the fair value of the leased asset/property.
  • There is a direct transfer of ownership of the leased asset or property (from the lessor to the lessee) at the end of the lease term. 
  • The asset or property is unique or specialized for the lessee's use only. At the end of the lease duration, the lessor does not have any alternative use for the leased asset or property.
  • The lessee enjoys an option to purchase the leased property at a lower price than the prevailing fair value. This option is known as the bargain purchase option due to the lower price.

Why is Lease Accounting Important?

Accounting is a crucial aspect to see and assess how a company's financial health is doing. This is simply because there are multiple aspects of accounting to take into account in lease accounting.

Each of these aspects has a role to play in offering financial insights that can influence organizational business strategy and decision-making in the long run.

Apart from this, lease accounting is also important for the following reasons:

  • Helps understand the specifics of lease classification and stay updated on the lease accounting standards which are currently in effect.
  • Lease accounting clarifies how it impacts and works in sync with each financial statement so you can accurately take your business decisions and organizational strategies.
  • Regardless of the fact that your company is the lessor or the lessee, lease accounting and the way you keep track of facets such as your income,  expenses, assets, and liabilities generated by leasing help understand the impact of the company’s financials.

To Sum It Up 

The lessee and the lessor are the two key parties in any lease agreement. Irrespective of the type of lease (an equipment lease or a commercial lease), it is essential to comprehend the main responsibilities between the two since the accounting differs for each.

Further, when it comes to determining if leasing is right for your business, you need to consider a lot of variables. To make it more complex, the new accounting standards are hard to navigate and create significant lease accounting challenges to handle for businesses.

Leveraging a good automated lease accounting software is a great choice here as it helps better manage the lease accounting challenges and allows businesses to make strategic and better decisions by focusing on the advantages and disadvantages of leasing for their business.

If you are looking for a one-stop solution for everything lease-related - management, administration, accounting, and more, LeasO serves as an excellent choice. With LeasO, the go-to lease management software, you can centralize, automate and manage your end-to-end leasing needs without any hassle.

Contact us to learn more.

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