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Lease accounting is the process organizations use to record the financial impact of their leases. Entities are now required to record the majority of their leases on the balance sheet following the release of the new lease accounting standards.
This area of accounting has undergone many changes after recent pronouncements. The new lease accounting standards, which are mandatory, require entities to record the majority of their leases to the balance sheet, including operating leases, whereas the old standards only required this for capital/finance leases.
A lessor is defined as an entity (i.e. a person, company, or organization) providing the right to use an asset for a period of time in exchange for consideration. One of the more common scenarios of a lease agreement is an entity renting their owned property to another entity for a monthly cash payment. For example, if an organization owns a building and leases the right to use the building or space within the building, the owner of the building is the lessor, also commonly referred to as the landlord.
The legacy lease accounting standards included ASC 840, IAS 17, and various GASB standards, mainly GASB 13 and GASB 62. Before the announcement of new lease accounting standard requirements, most companies did not find it essential to pay close attention to operating leases within the financial reporting process. This was because lessees with operating leases would only recognize an expense over the lease term with limited balance sheet impact.
The most complex accounting for leases under the old standards was for capital leases, known as finance leases under IAS 17 because the old standards required these leases to be recorded on the balance sheet. The capitalized assets and liabilities related to capital/finance leases were recognized on financial statements and amortized over a specific period.
Initially, the FASB worked in conjunction with the International Accounting Standards Board (IASB) to develop their new standards. The GASB developed its standards independently and there are some notable differences.
All companies that lease assets are affected by the new standards. Some considerations exist within each standard to omit specific types of transactions from capitalization (i.e. short-term leases). However, all companies with the right to use at least one in-scope asset qualifying as a lease will need to apply the new standard.
The primary change to lease accounting under the new standards is that organizations must now recognize lease assets and lease liabilities on the balance sheet for most of their lease arrangements. Lessees are required to calculate the present value of future lease payments to establish a lease liability and the related ROU asset.
Under ASC 842, the new lease accounting standard for US companies following US GAAP, lessees are required to recognize lease assets and lease liabilities on their balance sheets for both operating and finance (previously capital) leases. The lessee is required to perform a present value calculation of future expected lease payments to establish the lease liability and the related ROU asset. Accounting for leases classified as operating leases is affected the most, as leases classified as capital leases were already recognized on the balance sheet under ASC 840. ASC 842 is effective for nonpublic entities for fiscal years beginning after December 15, 2021, and December 15, 2019, for publicly-traded companies.
Lessees and lessors have the option to elect a package of practical expedients to aid in the adoption of the new standard, in which the lessor is not required to reassess lease classification. Therefore, we expect many lessors to elect this expedient and retain previously established lease classifications when transitioning from ASC 840 to ASC 842.
While the lessee model for IFRS 16 is a single model approach, for lessors the operating and finance classification model continues. Lessors are required to determine if a lease is classified as an operating or finance lease and use the appropriate accounting treatment.
The main driver between operating and finance leases for lessors under IFRS 16 is transfer of ownership. Lease agreements where the lessor maintains ownership are operating leases. For operating leases, the lessor continues depreciating the leased asset and records the incoming lease receipts as revenue on a straight-line basis over the lease term.
When the lease agreement is classified as a finance lease, the lessor will calculate the net investment in the lease using the present value of future expected lease receipts and record this amount as a receivable. Lessors are also required to derecognize the carrying value of the underlying asset. Any difference between the net investment in the lease and the carrying value of the underlying asset is recognized as a gain or loss on the income statement.
Government entities reporting under GASB 87 recognize a lease liability and related lease asset at the commencement date of the lease. The lease liability is equal to the present value of the expected lease payments over the lease term and the related lease asset is equal to the lease liability with a few minor adjustments. GASB 87 is effective for fiscal years beginning after June 15, 2021.
Like IFRS 16, GASB 87 also uses a single model approach, in which all leases are classified as finance leases. Under the new standard, recognizing a lease liability and lease asset for all leases formerly classified as operating is a significant change.
Lessors under GASB 87 record a lease receivable and a deferred inflow of resources at the commencement of the lease term. As with the lease liability for a lessee, the lease receivable is calculated as the present value of the lease receipts expected during the lease term. The deferred inflow of resources is equal to the lease receivable with a few minor adjustments and is similar to deferred revenue.
The GASB intended for lessor accounting to effectively mirror lessee accounting under the new lease accounting standard. This is accomplished by the lessee and the lessor recognizing the present value of the expected remaining lease payments or receipts, respectively, offset by the corresponding ROU asset and deferred inflow of resources.
The impetus behind the standard changes was to enhance transparency into financial obligations. Leases have long been a blind spot for financial statement users. Each of the standards requires entities to bring most leases onto the balance sheet.
Before you begin preparing your financial reports, you need to get a deeper understanding of what the standards require. There is a complex set of calculations you have to complete to be fully compliant. Below are some calculations that are necessary to account for your leases under the new standards and successfully navigate your transition:
Present value is the calculation of what a future sum of money or stream of cash flows is worth today given a specified rate of return over a specified period. Under the new lease accounting standards, lessees are required to calculate the present value of any future lease payments to determine the obligations to be recorded on the balance sheet for both operating and finance leases. The calculation is performed using the term and payments specified in the lease and a rate of return that is specific to either the lease or the organization. The present value of the lease payments is used to establish both a lease liability and a right-of-use asset.
The concept of straight-line rent expense requires lessees to charge their total lease liability to expense on an even, periodic basis over the lifetime of the contract. Similar to straight-line depreciation, this method is required to evenly recognize a fixed asset over its useful life. Similarly, straight-line rent expense is calculated by aggregating all rent payments and dividing them by the full contract term.
One of the biggest challenges entities face when compiling their lease portfolio involves identifying their embedded leases. A typical real estate lease can require legwork to gather the appropriate data, but the process of identifying the lease itself does not provide immense difficulty.
Embedded leases, which refer to leased assets provided within service, outsourcing, and maintenance contracts, may require additional work to discover. Examples of contracts that can contain embedded leases include
Departments responsible for procurement will not typically have a comprehensive understanding to know whether the contract includes any assets that qualify as an embedded lease. The process of dissecting each contract for embedded lease assets might just earn the title of the most daunting exercise that the lease accounting transition requires.
Excel has limitations when considering the complexity of the new standards. For example, when considering the practical expedients offered by the boards, Excel does not offer the capabilities of building those elections into a spreadsheet. This is one of the reasons why audit firms suggest using software for compliance.
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