Many businesses are involved with some type of leasing or rent-to-own transactions. Some lease property while others lease equipment to run their operations. Others are the ones leasing those things out to others as a source of revenue.
New lease accounting standards have been put in place in the last few years that are having a significant impact on how leasing activities affect your company’s books. It’s important to understand exactly how they work.
In this post, we’ll explore accounting for leases and how you can make sure you’re handling everything correctly.
Accounting For Leases
Lease accounting is simply how businesses record the financial aspect of their leasing actions.
When a business leases a particular property (for example, a bay in a strip mall) or a piece of equipment (a backhoe) as part of its operational activities…or when a business makes money doing the leasing, those things have to be recorded in their financial statements. How you record it depends on whether you are the owner of the asset in question or not as well as other factors that we will look at in more detail in a moment.
There are two types of lease accounting. You must know the difference so you will know how to correctly account for the money you make or spend in those areas.
Finance Lease Accounting
More commonly referred to as “rent-to-own”, finance leases are ones in which a company or individuals lease an item from a company with the agreement that ownership of that item will transfer to the lessee at the end of the term. They were previously called “capital leases”, but that has since changed with the adoption of new lease accounting standards which we discuss later.
These kinds of arrangements are beneficial to many people since they allow them to purchase things over time that might otherwise be too expensive to buy outright. Think of businesses like “Rent-A-Center or Aaron’s Rental” where you can get furniture, appliances, electronics (…even tires and jewelry) for personal use. Business applications of the same concept might include office furniture, printers, or other expensive and specialized pieces of equipment.
The downsides of this type of leasing are that rental prices may be higher since part of your payment is being applied to the purchase price, extra nonrefundable fees may be involved, and the lessee may be responsible for covering the costs of repairs.
Operating Lease Accounting
According to Investopedia, “An operating lease is a contract that allows for an asset’s use but does not convey ownership rights of the asset.” In other words, when you enter into an operating lease you get to use whatever it is you are leasing, but someone else still remains the owner.
When you go to a “big box” hardware store and rent a tool for the day you get to use that tool as much as you want. However, the store still owns it. They have the right to tell you when to return it (in good condition), and they can charge you penalty fees according to the contract you signed if you don’t keep your end of the agreement.
The same would be true for a rental car, Air BnB, storage unit, or any number of other things. The advantages for the leasee are that, since they aren’t the owner, they are not responsible for maintenance and repairs. Renting/leasing is usually less expensive than purchasing the item. And since these types of leases are typically short, the lessee isn’t locked into any long-term arrangement if the item is no longer needed.
In the past, accounting for operating leases did not list them on the company’s balance sheet. However, all of that changed when new lease accounting standards were released.
New Lease Accounting Standards
So, what are the new lease accounting standards we mentioned earlier?
From 1976 until 2016, businesses that were involved with leasing (either as owners or renters) operated under standards that were commonly referred to in accounting circles as “ASC 840.” The new lease accounting standards are known as “ASC 842.”
ASC 842
ACS 842 is designed to simplify how leases are documented on financial statements and create more financial transparency. Under the old standards finance lease accounting wasn’t necessarily reflected on the balance sheet while operating leases were. Now, all lease activity that lasts 12 months or longer must appear on your company’s balance sheet. (Leases shorter than 12 months are simply listed as operating expenses as in the past.)
Even though these new regulations were passed in 2016, they were not put into effect right away. Public companies had to switch from ACS 840 to 842 by 2019, and the plan was for private companies to change over by 2020.
Then came COVID-19.
Because of the global economic disruptions caused by the pandemic, the Financial Accounting Standards Board (FASB) issued an extension to private companies. They were given until their fiscal years beginning after December 15, 2021 (and 2022 in some cases) to adopt ASC 842.
(For further reading, see this “Complete Guide to ASC 842 Journal Entries” from Leasecrunch.com.)
Lease Liability On The Balance Sheet
Three things are needed to accurately calculate lease liability on the balance sheet. They each have the potential to be complicated, so be sure to check with a good CPA if you have questions.
- The Lease Term – How long is the lease agreement? If over 12 months, it goes on the balance sheet. If under 12 months, it is an ordinary expense. Contract options involving renewals and early terminations can affect how this is determined.
- The Lease Payment – This included fixed payments, variable payments, and payments related to renewals or terminations, so it may not be a simple number.
- The Discount Rate – This could be the rate stated in the lease, or it could be what is known as an “incremental borrowing rate” (IBR) if a discount rate isn’t obvious.
What Is Straight Line Rent?
Sometimes lease agreements involve different rates at different points in the lease term. But you want to record them evenly on your books (similar to straight-line depreciation of an asset). In that case, you simply add the total cost of the rent payments and divide them by the term of the agreement.
(For more on this, take a look at “How to Calculate Straight Line Rent” from Accountingtools.com.)
What Is An ROU Asset?
As a side note worth mentioning, there are times when you may be leasing the right to use an asset rather than the actual asset itself. This is known as a “Right Of Use (ROU) Asset.” An example of this might be when you rent a bay in a strip mall to operate your business.
Along with direct costs and prepayments associated with leasing, there are often incentives given (cash, help with moving costs, etc.) designed to entice you into a lease in that particular location.
So the formula to calculate an ROU asset looks like Initial Direct Costs + Prepayments – Incentives = Lease Liability. That total is what you would enter on your balance sheet.
Your Dedicated Lease Accountants
If you run a rent-to-own business (or are a regular customer of one), the new accounting standards mean big changes in the way you record transactions.
We fully understand that the new lease accounting standards can be much more complicated than what we’ve covered here in this overview. There are a lot of pieces to the puzzle depending on the complexity of your business and your particular lease situation.
But we believe that you deserve the best information and good help when you need it. So to help you make sure that you stay on top of all the changes and keep your company running strong, schedule a call with one of our accounting experts today.
