In an earlier post on new lease accounting standards and how they can impact your business, we discussed a couple of different types of leases. Because most business owners are involved with renting some type of property or equipment regularly, we thought it might be a good idea to dive a little deeper into operating lease vs finance lease arrangements.
In this post, we’ll cover the differences, the rules involved, and how to ensure you’re doing your accounting right so you don’t accidentally create problems with your bookkeeping.
Operating Lease vs Finance Lease
The simplest way to understand the difference between an operating lease vs finance lease is to think about who owns the item in question.
With a finance lease, the renter will eventually become the owner, assuming that everything works out and both parties fulfill the agreement through to the end. With an operating lease, the renter has permission to use the item during the agreement term but never becomes the owner.
What Is A Finance Lease?
A finance lease is essentially a renamed version of the old “capital” lease. As we mentioned above, a finance lease is an arrangement in which the renter/lessee eventually becomes the purchaser of the product in question. It remains under the ownership of the lessor until that point.
In the past (prior to new lease accounting standards which we’ll discuss in a minute) there were only two categories of leases: “capital” or “operating.” Since new standards became effective in 2016, we now have “finance leases” and “operating leases.” Capital leases have been replaced with finance leases. So what is a finance lease?
An example of this kind of lease would be what you would find at a “rent-to-own” store like Aaron’s, BestWay, or Rent-A-Center. It is promoted in this type of scenario as a good alternative for people who have bad credit or simply aren’t able to purchase big-ticket items outright. As Aaron’s website says, “All lease renewal payments go toward ownership.”
Finance Lease Rules
There are four finance lease “rules” that need to be in place for a lease to be considered a “finance” lease.
- A transfer of ownership. At the end of the lease term, the renter/lessee expects to become the owner of the leased item or property, and the details of that transfer are spelled out in the lease agreement with payments being applied to that end.
- A long-term agreement. Finance leases generally have longer term periods than operation leases.
- A transfer of risk. In a finance lease, the renter/lessee assumes responsibility for the maintenance and upkeep of the item/property being leased. (In most short-term operational leases, the owner bears that risk.)
- A difference in accounting. The length of a finance lease also affects your bookkeeping. Leases longer than 12 months must be recorded on a company’s balance sheet as an asset and liability since the renter/lessee is taking on more of the ownership risks and rewards throughout the lease. (More on that in the next section.)
Lease Accounting Standards
In 2016, the Financial Accounting Standards Board released new guidelines regarding leasing. Among several other updates (related to municipalities and other government entities), these lease accounting standards replace previous guidelines for public and private businesses which were commonly known as “ASC 840.”
The goal of all of the new lease accounting standards is to create better transparency on financial statements to help prevent fraud and misuse.
ASC 842
ASC 842 is the new lease accounting standard for businesses. It came about due to the collapse of Enron which began in 2001. It was a company that was valued much higher than it was. In reality, it was a very risky business to invest in. However, investors couldn’t easily see that because most of their leasing activity was hidden. Old standards only required capital leases to be listed on a company’s balance sheet. As a result of the financial disasters created in the wake of Enron, the FASB was given the task of improving transparency.
ASC 842 now requires all leases longer than 12 months to be recorded on a company’s balance sheet. However, a renter/lessee can choose to record leases that are shorter than 12 months in length off of their balance sheets as in the past.
With finance leases, companies must now recognize asset and liability values equal to the current value of their lease payments. For operating leases, they must show a lease liability and a “Right of Use” asset on their balance sheet.
Companies will now be required to do more internal work to stay on top of details about their leases including terms, payments, and renewal options than they did in the past.
Public companies have had to use the new lease accounting standards since 2018. After a brief pause due to COVID-19, private companies are now being required to adopt these standards as of 2021 (and 2022 in some cases). Now that we are well into 2024, everyone should be on board.
Since your company will be affected by these new ASC 842 standards somehow, it will be well worth your time and effort to set up good workflows and organizational methods regarding your leases. You will also want to be sure all of your staff is trained on how to handle things going forward.
(For further reading, Deloitte has a very informative page dedicated to “New Leasing Standards: What Private Companies Need To Know”)
Skip The Stress. Trust Us To Be Your Lease Accountant.
We realize that these new lease accounting standards create a lot of extra work and confusion for small business owners who rely on leased properties and products to run their companies. It can be tough to switch to new methods after doing things a certain way for so long.
We believe you deserve to grow your business without the burden of extra regulations wearing you down.
That’s why our accounting pros are standing by to help. We’ve got over 40 years of experience under our belts, so we’ve navigated many accounting regulation changes. We can guide you through this one too. To learn more, schedule a call with one of our team members today!
