Lease Accounting: A Practical Guide for Businesses

What is Lease Accounting?

Definition and Purpose

Lease accounting refers to the method by which businesses track and report leased assets and related obligations. The main purpose is to record and present leases in a way that complies with accounting standards, providing accurate financial reporting. Lease accounting involves the use of two key components: right-of-use assets and lease liabilities, ensuring companies accurately reflect their leased assets on balance sheets and manage the financial impacts in their income statements and cash flow reports.

Key Lease Accounting Principles (IFRS 16 & ASC 842)

There are two primary accounting standards for lease accounting: IFRS 16 and ASC 842. These standards lay out the treatment of leases and the related reporting requirements.

• IFRS 16 (International Financial Reporting Standard 16) is used by public companies worldwide. It mandates that most leases be recorded on the balance sheet, which was a significant shift from previous standards.
  
• ASC 842 (Accounting Standards Codification 842) applies in the United States and is closely aligned with IFRS 16, although there are some differences in how leases are handled for private companies.
  

Both standards require businesses to recognize leased assets and liabilities, offering a clearer representation of a company’s financial health. This helps prevent off-balance-sheet financing, which was common under the previous rules.

How Lease Accounting Affects Financial Reporting

Balance Sheet Impact

A significant change under both IFRS 16 and ASC 842 is the impact on the balance sheet. Previously, operating leases were not recorded on the balance sheet, with only lease payments shown as expenses in the income statement. Under the new rules, right-of-use assets and lease liabilities must be recognized on the balance sheet for most leases.

• Right-of-use asset: This represents the lessee’s right to use the leased asset during the lease term and is recorded as an asset.
  
• Lease liability: This reflects the present value of lease payments due over the term of the lease and is recorded as a liability.
  

As a result, businesses report higher assets and liabilities, which impacts financial ratios such as return on assets (ROA), debt-to-equity ratio, and working capital.

Income Statement & Cash Flow Considerations

Lease accounting also impacts the income statement and cash flow statements.

• Income Statement: Instead of lease expenses being recorded as rent under operating leases, businesses now recognize depreciation on the right-of-use asset and interest on the lease liability. This typically results in higher expenses in the earlier years of the lease term.
  
• Cash Flow Statement: Lease payments are classified differently under the new rules. Payments related to the lease liability are shown as financing activities, while depreciation is categorized as an operating activity. This changes how cash flows are presented in the financial statements.
  

These changes can make cash flow appear stronger for businesses that previously treated leases as operating expenses.

Lease Classification: Operating vs Finance Lease

Criteria for Each

Leases are classified into two types: operating leases and finance leases, based on specific criteria outlined by accounting standards.

• Operating Lease: This type of lease is generally short-term, where the lessee does not assume most of the risks and rewards of ownership. It typically applies to things like office space or equipment rentals, where the lessee doesn’t have the option to purchase the asset. Under previous standards, operating leases were off the balance sheet, though now, they are mostly recognized.
  
• Finance Lease: Also known as a capital lease, a finance lease involves a long-term lease arrangement where the lessee takes on the risks and rewards of asset ownership. Examples include leasing machinery or vehicles, where the lease term covers most of the asset’s useful life. In this case, both the asset and liability are recorded on the balance sheet.
  

The classification depends on factors like the lease term, the transfer of ownership at the end of the lease, and the present value of the lease payments.

Examples and Treatment Differences

• Operating Lease Example: A business leases office space for five years. The lease term is short and does not transfer the risks and rewards of ownership. This would be classified as an operating lease.
  
• Finance Lease Example: A business leases equipment for eight years with an option to buy at the end. The lease term covers most of the asset’s useful life, and the business assumes the risks and rewards of ownership. This would be classified as a finance lease.
  

Although the classification and treatment differ between the two types, both are now recognized on the balance sheet under the new accounting standards.

Lease Accounting Software: Why It Matters

Manual Spreadsheets vs Automation

In the past, many businesses relied on spreadsheets to track their lease obligations. This method works for a small number of leases but becomes cumbersome as the volume increases. Spreadsheets are prone to errors, lack consistency, and require manual effort to update, especially when calculating depreciation, lease liabilities, and their impact on financial statements.

In contrast, lease accounting software automates the process, reducing errors and saving time. The software ensures compliance with standards like IFRS 16 and ASC 842, streamlines reporting, and provides real-time access to accurate data. Features like automatic lease calculations, schedule generation, and document storage make managing leases easier, allowing businesses to keep their financial data up to date and compliant.