Lease accounting
/What is a Lease?
A lease is a contractual agreement in which one party (the lessee) obtains the right to use an asset owned by another party (the lessor) for a specified period in exchange for periodic payments. Leases are commonly used for property, equipment, or vehicles and can be structured as operating or finance leases. The lessee typically gains access to the asset without having to purchase it outright, conserving capital while still meeting operational needs. Depending on the lease terms, the lessee may also be responsible for maintenance, insurance, or even the option to purchase the asset at the end of the lease.
What is Lease Accounting?
Lease accounting is the process of recording and reporting lease transactions in an organization's financial statements in accordance with applicable accounting standards, such as ASC 842 or IFRS 16. It requires lessees to recognize most leases on the balance sheet by recording a right-of-use asset and a corresponding lease liability. The accounting treatment varies based on whether the lease is classified as a finance lease or an operating lease, affecting how expenses are recognized in the income statement. For lessors, lease accounting involves determining whether a lease is a sales-type, direct financing, or operating lease, which dictates how revenue and assets are reported.
Lessee vs. Lessor
In a lease arrangement, the lessee is the party that obtains the right to use an asset owned by another party for a specified period in exchange for periodic payments. The lessee does not own the asset but gains control over its use under agreed-upon terms, such as duration, payment amounts, and maintenance responsibilities. The lessor, on the other hand, is the owner of the asset who grants the usage rights to the lessee while retaining legal ownership. The lessor receives lease payments and may impose conditions to protect the asset’s value and ensure proper use. This relationship allows the lessee to access necessary assets without a large upfront investment, while providing the lessor with a steady income stream.
Lease Classifications for a Lessee
The choices for a lessee are that a lease can be designated as either a finance lease or an operating lease. A lessee should classify a lease as a finance lease when any of the following criteria are met:
Ownership of the underlying asset is shifted to the lessee by the end of the lease term.
The lessee has a purchase option to buy the leased asset, and is reasonably certain to use it.
The lease term covers the major part of the underlying asset’s remaining economic life. This is considered to be 75% or more of the remaining economic life of the underlying asset.
The present value of the sum of all lease payments and any lessee-guaranteed residual value matches or exceeds the fair value of the underlying asset.
The asset is so specialized that it has no alternative use for the lessor following the lease term.
When none of the preceding criteria are met, the lessee must classify a lease as an operating lease. An operating lease is the rental of an asset from a lessor, but not under terms that transfer ownership of the asset to the lessee. During the rental period, the lessee typically has unrestricted use of the asset, but is responsible for the condition of the asset at the end of the lease, when it is returned to the lessor.
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Lease Classifications for a Lessor
The choices for a lessor are that a lease can be designated as a sales-type lease, direct finance lease, or operating lease. If all of the preceding conditions just noted for a lessee’s finance lease are met by a lease, then the lessor designates it as a sales-type lease. If this is not the case, then the lessor has a choice of designating a lease as either a direct financing lease or an operating lease. The lessor should designate any remaining lease as a direct financing lease when both of the following criteria are met:
The present value of the lease payments and any residual asset value that is guaranteed by the lessee or any other party matches or exceeds substantially all of the fair value of the underlying asset. In this context, “substantially” means 90% or more of the fair value of the underlying asset.
The lessor will probably collect the lease payments, as well as any additional amount needed to satisfy the residual value guarantee.
When none of these additional criteria are met, the lessor classifies a lease as an operating lease.
Lessee Accounting for a Lease
As of the commencement date of a lease, the lessee measures the liability and the right-of-use asset associated with the lease. These measurements are derived as follows:
Lease liability. The present value of the lease payments, discounted at the discount rate for the lease. This rate is the rate implicit in the lease when that rate is readily determinable. If not, the lessee instead uses its incremental borrowing rate.
Right-of-use asset. The initial amount of the lease liability, plus any lease payments made to the lessor before the lease commencement date, plus any initial direct costs incurred, minus any lease incentives received.
When a lessee has designated a lease as a finance lease, it should recognize the following over the term of the lease:
The ongoing amortization of the right-of-use asset
The ongoing amortization of the interest on the lease liability
Any variable lease payments that are not included in the lease liability
Any impairment of the right-of-use asset
When a lessee has designated a lease as an operating lease, the lessee should recognize the following over the term of the lease:
A lease cost in each period, where the total cost of the lease is allocated over the lease term on a straight-line basis.
Any variable lease payments that are not included in the lease liability
Any impairment of the right-of-use asset
Lessor Accounting for a Lease
In a sales-type lease, the lessor is assumed to be selling a product to the lessee, which calls for the recognition of a profit or loss on the sale. Consequently, this results in the following accounting at the commencement date of the lease:
The lessor derecognizes the underlying asset, since it is assumed to have been sold to the lessee.
The lessor recognizes a net investment in the lease. This investment includes the following:
The present value of lease payments not yet received
The present value of the guaranteed amount of the underlying asset’s residual value at the end of the lease term
The present value of the unguaranteed amount of the underlying asset’s residual value at the end of the lease term
The lessor recognizes any selling profit or loss caused by the lease.
The lessor recognizes any initial direct costs as an expense, if there is a difference between the carrying amount of the underlying asset and its fair value. If the fair value of the underlying asset is instead equal to its carrying amount, then defer the initial direct costs and include them in the measurement of the lessor’s investment in the lease.
In addition, the lessor must account for the following items subsequent to the commencement date of the lease:
The ongoing amount of interest earned on the net investment in the lease.
If there are any variable lease payments that were not included in the net investment in the lease, record them in profit or loss in the same reporting period as the events that triggered the payments.
Recognize any impairment of the net investment in the lease.
Adjust the balance of the net investment in the lease by adding interest income and subtracting any lease payments collected during the period.
At the commencement date of a direct financing lease, the lessor engages in the following activities:
Recognize the net investment in the lease. This includes the selling profit and any initial direct costs for which recognition is deferred.
Recognize a selling loss caused by the lease arrangement, if this has occurred
Derecognize the underlying asset
In addition, the lessor must account for the following items subsequent to the commencement date of the lease:
Record the ongoing amount of interest earned on the net investment in the lease.
If there are any variable lease payments that were not included in the net investment in the lease, record them in profit or loss in the same reporting period as the events that triggered the payments.
Record any impairment of the net investment in the lease.
Adjust the balance of the net investment in the lease by adding interest income and subtracting any lease payments collected during the period.
Related Articles
Accounting for a Finance Lease
The Difference Between a Finance Lease and an Operating Lease