Everything About Accounting for Leases – Meaning And Basics

If your company rents or leases its assets from others, you need to track the financial impact of those activities on your company's financial position. This is known as lease accounting that helps you in assessing legal obligations and running an organized and successful business.

Here's what we will be going through:

• What is a lease invoice?
• Categories of leases
• The Old and New Lease Accounting Standards
• About Credential of Readiness (CORe)
• Accounting for leases by lessors
• Lessor Accounting for a Lease
• About AS19-Rental Contract accounting
• Difference between AS19 and IAS17 accounting
• Differences between IAS17 and IFRS16 accounting

What is a Lease Invoice?

Lease accounting is the financial impact of a company's leasing activities. Leases that meet certain classification requirements must be recorded in the company's financial statements.

The outline of each financial statement is as follows:

1. The balance sheet represents a company's assets, liabilities, and capital and should always be balanced
2. The cash flow statement shows the movement of money inside and outside the company over some time
3. The income statement captures the company's income and expenses over time
4. The way a lease is recognized in each financial statement depends on whether you are a lessor (owning the asset and receiving payment from the lessee) or a lessee (paying to use the lessor's asset)
5. These accounting strategies will give you a clear picture of the impact of leasing on your overall financial position and the value of your company's assets

Categories of Leases

There are two categories of leases - operating leases and finance, which determine how a company accounts for leases based on the length of the lease in the financial statements.

Operating Leases

An operating lease is a lease that does not allow the lessee to take ownership of the asset. According to the new accounting rules, operating leases are recorded on the company's balance sheet only if the lease term exceeds 12 months. If the lease term is 12 months or less, the Financial Accounting Standards Board (FASB) does not require an accounting.

For operating leases of up to 12 months:

• The lessor reports the payments related to individual lease as income statement revenue on the income and cash flow statements
• The lessee reports the payments or installments related to individual leases as operating expenses on the income statement
• For operating leases that have been attributed with a term of more than 12 months
• The lessor reports the lease as an asset on the balance sheet and reports the individual lease payments as income statement revenue. He also considers the depreciation of his assets over time
• The lessee reports the balance sheet leases as both assets and liabilities and reports the payment of individual leases as an income statement expense

Financing Leases

A finance lease, formerly known as a capital lease, is a lease that reasonably expects the lessee to take ownership of the asset. There are five standards in the US General Accounting Principles (US GAAP), and only one of them must be met for a lease to be considered a finance lease.

• By the end of the rental period, the lease gives them ownership of the underlying asset to the lessee
• Leasing gives an option to the lessee to buy the underlying asset that the lessee is sure to exercise
• The lease term is most of the remaining useful life of the underlying asset unless the start of the lease coincides with or is near the end of the useful life of the underlying asset
• The present value of the total lease payments and the residual value guaranteed by the lessee are equal to or significantly higher than the fair value of the underlying asset
• The underlying asset is specialized so that it has no alternative to the lessor at the end of the lease term

For financing leases, regardless of the term:

• The lessor reports it on the balance sheet as a leased asset and treats the individual lease payments as income statement revenue
• The lessee recognizes the lease as both an asset and a liability on the balance sheet due to the share of the potential owner of the asset and the required payment. In addition, they show individual lease payments as an income statement expense

The Old and New Lease Accounting Standards

The original lease accounting standard, known as Financial Accounting Standards Foundation 13 (SFAS13) or US GAAP Accounting Standards Coded (ASC) 840, was issued by FASB in 1976.

• Finance leasing, then known as capital leasing, had different standards than above
• Lease transfers ownership of the leased item to the lessee at the end of the lease term
• The lease has an option included that permits the lessee to purchase the leased asset at a reasonable price by the end of the lease term
• The lease term is at least 75% of the useful life of the asset
• The current value of the bare lease payment is at least 90% of the fair value of the rental asset
• Start of lease - Until now, operating leases have typically not been recorded. To avoid reporting capital leases, lenders bypass capital lease criteria and make them look like operating leases
• This is because tax obligations are reduced if these leases are not taken into account

About Credential of Readiness (CORe)

The FASB issued a new accounting standard for leasing called Accounting Standards Update 201602 (ASU201602) or US GAAP ASC 842 in February 2016, for listed companies and for private companies in December 2018. It went into effect a year later. As of now, all leases that have a term of more than 12 months must appear on the balance sheet, regardless of classification.

Accounting for leases by lessors

From the start of the lease, the lessee evaluates the debt and usage rights associated with the lease. These evaluations are as follows:

1. Lease liability

This is the present value of lease payments. It is discounted at the discount rate of the lease. This fee is included in the rental agreement if this fee can be easily determined. If not, the lessee will use the incremental borrowing rate instead.

2. Right-of-use asset

The lease liability amount, in the beginning, adds the lease payments paid to the lessor before the start of the lease, plus the initial direct costs incurred minus the lease incentives received.

If the lease is designated as a financing lease by the lessee then he must record the following over the lease term:

• Current depreciation of the right-of-use asset
• Current depreciation of interest on the leased liability
• All variable lease payments not included in the lease liability
• Depreciation of the right-of-use asset

If the lessee labels the lease as an operating lease, he should be aware of the following:

• Lease cost at each period, if the total cost of the lease is linear throughout the distributed lease
• Lease all variable lease payments not included in the liability
• All impairment losses on assets from the right to use

Lessor Accounting for a Lease

A sale-type lease assumes that the lessor is selling the product to the lessee and requires recognition of the profit or loss from the sale. This causes the following accounting treatment at the start of the lease:

• The lessor unregisters the underlying asset as it is expected to be sold to the lessee
• The lessor keeps a note of the net investment in the lease. This investment includes
• Present value of unreceived lease payments
• Present value, at the end of the lease term, of the guaranteed and unguaranteed residual value of the asset

Value of Assets - The lessor records the capital gains or losses incurred by the lease. The lessor considers all initial direct costs as expenses if there is any difference between the carry forward amount and the fair value of the asset.

If the fair value of the underlying asset corresponds to its carrying amount, the initial direct cost must be deferred and included in the assessment of the lessor's participation in the lease.

In addition, after the lease begins, the lessor should consider the following:

• Current interest income from a net investment in the lease
• If variable lease payments are not included in the net investment in the lease, they will be recognized in profit or loss during the same reporting period as the event that triggered the payment
• If any impairment, record a decrease in net investment in leases. Adjust the balance of your net investment in a lease by adding interest income and deducting the lease payments incurred during the period

At the start of a direct financing lease, the lessor does the following:

• Record a net investment in a lease. This includes sales profit and initial direct costs for which the record is postponed
• If there is a capital loss from the lease, he will recognize it
• Amortize the underlying asset

In addition, after the lease begins, the lessor should consider the following:

• Ordinary interest income on net investment in a lease
• To record them in profit or loss if variable lease payments are not included in the net investment in the lease. This will be done during the same reporting period as the event because of this the payment is triggered
• Record a decrease in net investment in leases
• Adjust the balance of net investment in a lease by adding interest income and deducting the lease payments incurred during the period

About AS19-Rental Contract

AS19 deals with accounting policies that apply to all types of leases.

A lease is a transaction with a lessee that makes a contract with the lessee for the lessee's right to use the asset in exchange for a single payment or a series of payments for the agreed period.

Which leases are not covered by this standard?

This standard does not apply to:

(A) Leases for exploring or using natural resources for example former oil, gas, wood, metal, and other mining rights

(B) License agreement for example former feature films, video recordings, plays, manuscripts, patents, copyrights

(C) Leasing of land used

Difference between AS19 and IAS17

1. Real Estate Lease

AS19 does not apply to real estate leasing. IAS17 contains specific provisions for leasing real estate and buildings.

2. Residual value

The term “residual value” is defined in AS19, and IAS 17 does not define “residual value”.

3. Inception and commencement

Both the terms are used in some parts of AS19, but these terms are not defined or distinguished. IAS 17 distinguishes between the inception of a lease and the commencement of a lease.

4. Recognizing lease

AS19 is recorded at the beginning of the lease. By IAS 17, the lessee shall record the financial lease as an asset and a liability on the balance sheet at the beginning of the lease term.

5. Lease Fee Adjustments

Not Handled by AS19. IAS 17 deals with lease fee adjustments paid during the period from the start of the lease to the start of the lease term.

6. Guidance

No Guidelines followed by AS19. IAS 17 provides guidelines for accounting for the following concepts - Incentives to operate a lease, investigate the substance of the transaction in the legal form of the lease, and determine if such an arrangement contains elements of the lease.

7. Upward revision

AS19 does not allow an upward revision of unguaranteed residual value during the lease term. IAS 17 permits an upward revision of the unguaranteed residual value during the lease term.

8. Depreciation method

For sale and leaseback transactions (for finance leases), AS 19 requires the seller (lessee) to defer sales that exceed the carrying amount of the asset and depreciate them over some time. IAS 17 of leases related to the depreciation of lease items provide that sales and leaseback transactions (for finance leases) require sales that exceed the carrying amount of the asset which is deferred and depreciated by the seller (tenant), but no depreciation method is specified

9. Classification of leases

These matters are not covered by the existing standards of AS19. IAS 17 requires that short-term and long-term classifications of leased liabilities also apply to other liabilities.

10. Allocation of lease rent

AS19 does not consider this, but according to IAS 17 if the increase in lease rent is due to expected general inflation, then it can compensate the lessor for expected inflation costs.

11. Initial Direct Expenses

In AS19, the initial direct expense incurred by the lessor (in the case of an operating lease) must be amortized as incurred or over the lease term. If a lessor incurs initial direct costs (in the case of an operating lease), it is the carrying amount of the leased item and is depreciated as an expense over the lease term.

Differences between IAS17 and IFRS16

IAS 17 puts all rents on an operating lease into the income statement on a straight-line basis unless another systematic standard is more appropriate if payments to the lessor are not made on a straight-line basis. For IAS17, if the lease rent has an inflationary factor, all expected rents should be calculated, evenly recorded in the income statement over the lease term, and leased for this excess/defect compensation account.

IFRS 16: For operating leases, all lease rents are recognized in the income statement according to the lease agreement unless payments to the lessor are configured to increase according to the expected general inflation rate. The lessor will cover expected inflation costs associated with the lease. This condition is not met if payments to the lessor fluctuate due to factors other than general inflation.

Conclusion

Bookkeeping is important for understanding a company's financial position. Bookkeeping is a tool that opens the door to important information, gains perspectives, provides useful insights, and assists in decision making.

Whether your company is a lender or a borrower, the way you track income, liabilities, assets, and expenses from leasing activities influences the overall picture of your company's financial position and thus its strategy.

Lease accounting is necessary to consider the nature of the transaction, its economic reality, rather than the exact legal form. In other words, you can use the transaction's legal basis to hide the essence of the transaction. It is claimed that lease accounting increases the reliability of the financial statements and ensures that the lease is faithfully reproduced.

Key Takeaways

• Leasing allows businesses to purchase critical equipment at no cost
• Capital leasing is a form of debt financing in which a lease acts as a loan
• Operating leases allow companies to purchase equipment with virtually no upfront investment, and lease payments are treated as deductible operating expenses

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