Lease accounting for your business: A fundamental overview

What is lease accounting and why does it matter?

Lease accounting is the set of rules that decide how a company records leases on its financial statements, and today most leases must appear on the balance sheet.

• It shows the real value of leased assets and lease liabilities.
• It affects key ratios, such as debt-to-equity and leverage.
• It follows ASC 842 under US GAAP and IFRS 16 under IFRS.

Lease accounting is a complex part of financial management. It affects businesses of all sizes.

The latest lease accounting standards have been in force for years. Yet many companies still find them confusing.

So in this article, we briefly compare the old and new lease accounting standards. We also explore why they matter to your business. Many firms now hand this work to an outsourced accounting team.

What is lease accounting?

Lease accounting refers to the reporting standards that dictate how companies record and report leases in their financial statements.

It means recognizing and measuring the financial impact of lease deals. This shows up on a company’s balance sheet, income statement, and cash flow statement.

Under lease accounting, companies must classify leases as operating or finance (capital) leases. They base this on specific criteria set by accounting standards.

Each class has its own treatment. So it decides how lease expenses are recognized over the lease term. It also decides whether the leased asset and matching liability sit on the balance sheet.

Evolution of lease accounting standards

Historically, many companies structured lease deals as operating leases. So they could keep lease obligations off the balance sheet. As a result, the business looked healthier, with lower leverage.

However, this approach lacked transparency. It made it hard for stakeholders to judge a company’s true position.

In response, accounting standards evolved to bring more transparency. So the new lease accounting standards now require most leases on the balance sheet. Modern accounting software makes that tracking far easier.

As a result, this change improves the accuracy of financial reporting. It also gives stakeholders a fuller view of a company’s lease commitments.

Lease accounting is crucial to financial reporting. It shapes a company’s ratios, debt levels, and overall performance. So proper implementation is essential for compliance.

Old vs. New lease accounting standards

Here is a quick overview of what the old and new lease accounting standards involve.

Old lease accounting standards

Old lease accounting had the following.

• Generally Accepted Accounting Principles (US GAAP) – ASC 840: Under ASC 840, operating leases were not recorded on the balance sheet. Instead, they were treated as off-balance sheet items. So they reduced visibility into a company’s lease obligations.
• International Financial Reporting Standards (IFRS) – IAS 17: IAS 17 also treated operating leases as off-balance sheet items. As a result, reporting was inconsistent, and it was hard to compare companies.
• Lease classification: Leases were classed as operating or finance (capital) leases. This was based on criteria such as transfer of ownership, bargain purchase option, lease term, and present value of payments.
• Financial statement impact: Operating leases were only disclosed in the footnotes. So users struggled to assess the true leverage of companies.

New lease accounting standards

Meanwhile, the new lease accounting standards cover the following.

• US GAAP – ASC 842: ASC 842 took effect for public companies in 2019. For private companies, it applies to fiscal years beginning after December 2021. So it now requires most leases on the balance sheet as a right-of-use (ROU) asset and a matching lease liability.
• IFRS – IFRS 16: IFRS 16, effective from January 2019, also requires lessees to recognize most leases on the balance sheet. These appear as ROU assets and lease liabilities. This change was made to improve transparency and comparability.
• Lease classification: The new standards remove the operating-versus-finance split for lessees. Instead, all leases are treated alike. Still, practical expedients exist for short-term leases and low-value assets.
• Financial statement impact: By showing lease assets and liabilities, the new standards reflect a company’s position more accurately. So users understand lease commitments more clearly.

Key similarities between old and new standards

Some parts stay much the same across the two standards.

• Definition of a lease: Both old and new standards define a lease as a contract. It conveys the right to use an identified asset for a set period in exchange for payment.
• Lessors’ accounting: The new standards do not change lessor accounting much. Under both, lessors still class leases as operating, sales-type, or direct financing.
• Lease term: Both require companies to consider the non-cancellable period. This includes renewal and termination options that are reasonably certain to be used.

In short, the main difference lies in how lessees account for leases.

Under the old standards, operating leases were off-balance sheet items. However, the new standards require lessees to recognize most leases on the balance sheet. These show up as ROU assets and lease liabilities.

How does lease accounting affect your business?

Lease accounting can have big effects on businesses. This is true for firms that lease assets or property as part of their work.

Here are some ways lease accounting affects businesses.

Balance sheet impact

The balance sheet is a snapshot of your assets, liabilities, and equity at a point in time.

Under the new standards, it now recognizes lease assets and lease liabilities. So this changes the total assets and liabilities shown.

As a result, it can shift key ratios, such as debt-to-equity and leverage. This may sway investors, lenders, and other stakeholders. A financial controller often leads this review.

Financial reporting transparency

Lease accounting matters because it affects reporting transparency. So it gives investors deeper insight into a company’s finances and model.

Without a clear view of the assets a company uses, you cannot make informed choices about investing. As a result, lease accounting reveals a company’s true condition.

Lease management and strategy

With lease data on the balance sheet, companies are prompted to manage leases more strategically.

So businesses can now review their lease portfolio more fully. As a result, they make better calls on renewals, terminations, and negotiations to cut costs. For this planning, some firms bring in outsourced CFO services.

Effect on earnings and cash flows

Lease accounting changes can affect reported earnings and cash flows.

Under the new standards, lease expenses are front-loaded. So costs run higher in the early years of a lease. As a result, this hits net income and operating cash flows. For smaller firms, sound bookkeeping for small businesses keeps these numbers clean.

Frequently asked questions about lease accounting

Quick answers to the questions businesses ask most about lease accounting.

What is the difference between ASC 842 and IFRS 16?

Both put most leases on the balance sheet. However, ASC 842 keeps a split between operating and finance leases for the income statement. IFRS 16 uses a single lessee model instead.

Do small businesses need to follow the new lease standards?

It depends on your reporting rules. Private firms that report under US GAAP follow ASC 842. Still, short-term and low-value leases have simpler options.

What is a right-of-use asset?

A right-of-use (ROU) asset is your right to use a leased item over the lease term. Under the new standards, you record it on the balance sheet with a matching lease liability.

How are operating and finance leases treated now?

For lessees under IFRS 16, the split is gone, so all leases look alike. Under ASC 842, both sit on the balance sheet, but expense patterns still differ.

Can you outsource lease accounting?

Yes. Many firms hand lease accounting to outside teams or software providers. As a result, they cut errors and stay compliant with less in-house effort.