Understanding Lease Accounting – What Is It and Why Is It Important?

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Written By Berry Mathew

The uncertainty in fast-changing and growing financial markets requires organizations to have a solid plan for their optimal capital structure. Technological advancement also stresses companies to upgrade obsolete equipment to improve productivity. It is especially vital from a corporate view, where companies must include lease accounting in their business strategies to address these needs.

Lease accounting is a financial solution implemented in private, public, and government organizations. It is a process to record the economic impacts of companies’ leasing activities in the form of financial, cash flow, and income statements. The accuracy of lease records gives a clear picture of the company’s financial standing and its impact on its overall financial health. 

The underlying reason for lease accounting is to let organizations use real estate properties and equipment for lease purposes without any hefty initial investment. It helps them to effectively manage cash outflows with expected cash inflows, thereby increasing the overall return on invested capital. Nowadays, most companies acquire equipment on lease.

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Lease Accounting Software

With the growing demand, the need for comprehensive and leading-edge software has also increased. It helps companies better manage the financial aspects of their leased assets. Additionally, it helps automate manual processes like lease data management and lease type, along with audit trials, accounting, and reporting processes.

With many options available in the market to effectively run core lease accounting processes, lease accounting by EZLease is an excellent choice. It guarantees ASC 842, GASB 96, and IFRS 16 easy and long-term compliance for lessees and lessors for both real estate and equipment leases. In addition to EZLease being cost-effective, it comes with a 15-day free trial that lets you evaluate it free of charge.

In addition to a centralized lease database and automated validation, it is easier to upload or update lease files either individually or in bulk, saving much time. It also makes reproducing and verifying large quantities of numbers in a report easier with its new audit reporting feature.

The tracking, updating, and managing leases through software ensures data accuracy, a must-have feature for disclosure reports from initial adoption to long-term reporting.  

Lease Accounting Standards

Due to the regulation of lease standards, there is a drastic change in the role of leases in accounting. It has a significant impact on a company’s financial position. The current lease standards, ASC 842, GASB 96, and IFRS 16, require the classification of all leases into assets or liabilities on the balance sheet.

  1. The Financial Accounting Standards Board (FASB) published ASC 842 to increase visibility into the lease obligations set for private and public sector organizations. This new accounting standard demands recording the right-of-use (ROU) of assets and liabilities for all leases with a period of more than 12 months on the balance sheet.
  2. The Government Accounting Standards Board (GASB) publishes the GASB 96 standard, which deals with accounting principles practiced by the state and local governments in the United States. Its main objective is to understand the lease obligations in financial disclosures.
  3. The International Accounting Standards Board (IASB) released a new IFRS 16 lease accounting standard that has changed the companies dealing with leases in their financial releases. It impacts the reporting requirements while considering financial instruments and revenue recognition.

Although the changes required for lease accounting standards are specified, companies still need help to collect the necessary inputs to comply with lease standards.

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Lease Classification – Operating Lease vs. Capital Lease

Lease accounting has two main types: operating and capital leases. 

  1. Operating leases allow the lessee to use an asset without giving the ownership rights. The lease agreement helps companies to use the asset at an affordable price for as long as required. The lessee has to return it in the same condition to the lessor.   

The lease term is less than 75% of the estimated useful life of an asset, whereas the present value of the lease payment is less than 90% of the market value of the equipment. The lessee cannot claim depreciation cost. 

  1. In capital leases, the lessee gets the ownership of the asset at the end of the lease period. The lessee must pay maintenance, insurance, and taxes and record payments. The contract includes the bargain purchase option. That means the price should be less than the market price.

The lease term should be more than 75% of the useful life of the leased asset, whereas the present value of lease payments should be more than 90% of the total cost of the leased asset. The lessee can claim depreciation cost every year. 

Importance of Lease Accounting

Lease accounting gives insights into a company’s financial health. These insights help gain perspective to devise a comprehensive organizational strategy. An understanding of all the details of lease classification with the appropriate knowledge of in-practice lease accounting standards aid in the decision-making process. Keeping track of income, expenses, assets, and liabilities can impact the company’s financials. 

Capital leasing treats the lease as a loan, such as debt financing. Operating leases function well in the case of expensive equipment where companies don’t need to pay an upfront amount. The payments recorded are treated as operating expenses. 

The new lease accounting standards require lessees to bring their lease details on the balance sheet. It helps to increase the transparency of the company’s lease obligations, which results in better financial reporting. This visibility is critical to gain and maintaining confidence in capital markets. 

Final Thoughts

Lease accounting plays a crucial role in understanding the nature of the transaction. It records and reports all the leased property that an organization holds or owns. 

The lease is either categorized as operational or capital. It increases the transparency of the financial statements and ensures that the whole process is well-organized and defined. 

The most significant aspect of lease accounting success is gathering accurate data and updating it as changes occur. The use of software solutions helps track, update and manage leases effectively and efficiently, thereby ensuring data accuracy, which is a must for disclosure reports.