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.
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.
There are three new accounting standards in recent times, which are discussed below:
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 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 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.
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:
Apart from several benefits, there can also be some disadvantages to leasing. Among these are:
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
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 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:
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:
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.
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:
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:
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.
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.
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.
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.
Lease accounting varies for lessors and lessees. In this section, we will see how the two differ:
At the beginning of a lease, the lessee is required to measure a lease’s:
It is also important to remember that when a lessee has designated a lease as a finance lease, it should recognize:
On the contrary, when a lessee has designated a lease as an operating lease, the lessee should recognize:
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:
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):
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:
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.