Lease Accounting Overview: New Standards, Compliance & Audit 

Last Updated on February 8, 2024 by Morgan Beard

What is Lease Accounting?

Lease accounting refers to the process of recording and reporting lease-related financial transactions according to specific accounting standards. It involves the recognition, measurement, presentation, and disclosure of lease-related information in financial statements. This article will provide a comprehensive overview of lease accounting, including the new standards, compliance requirements, and the role of auditing in the lease accounting rules.

The New Lease Accounting Standards:

Over the years, various accounting standards have been established to govern lease accounting practices. The most notable ones are ASC 842 (Accounting Standards Codification), IFRS 16 (International Financial Reporting Standards), and GASB 87 (Governmental Accounting Standards Board). These standards aim to provide a more transparent and accurate representation of a company’s financial position by analyzing their lease obligations and assets on financial statements.

ASC 842 Lease Accounting

ASC 842, issued by the Financial Accounting Standards Board (FASB), applies to private organizations, public companies, adn non-profits in the United States. It requires lessees to recognize most leases on their balance sheets as right-of-use assets and lease liabilities. Under the previous standard, leases were classified as operating leases and did not have to be recorded on the lessee’s balance sheet.

IFRS 16 Lease Accounting

IFRS 16, implemented by the International Accounting Standards Board (IASB), is the global equivalent of ASC 842. It also brings significant changes to lease accounting, requiring lessees to recognize leases on their balance sheets, similar to ASC 842.

GASB Lease Accounting

GASB 87 and GASB 96 are applicable to governmental entities in the United States. This standard follows a similar principle in recognizing leases on the balance sheet. It provides guidelines specifically tailored to the unique requirements of government accounting.

Why Were New Lease Accounting Standards Implemented?

Leases are an integral part of many businesses, allowing companies to access assets without owning them. However, under previous accounting standards like ASC 840 and IAS 17, operating leases did not require recording lease liabilities on the balance sheet. 

This allowed companies to keep significant financial obligations off their books. To improve transparency and accurately capture the economics of leasing, accounting standard setters issued major updates to lease accounting in 2016. These updates, known as ASC 842, IFRS 16, and GASB 87, require lessees to recognize right-of-use assets and lease liabilities for most leases. 

By bringing lease obligations onto the balance sheet, the new standards eliminate a form of off-balance sheet financing that companies used to make their leverage appear lower. Financial statement users now have a clearer picture of a company’s capital structure and can better compare companies that lease heavily to those that purchase assets outright. While adopting the new lease standards requires effort, the improvement in financial reporting transparency and comparability makes this essential update worthwhile for investors, creditors, and other stakeholders.

Lessee vs. Lessor Accounting Explained

In lease accounting, there are two primary parties involved: the lessee and the lessor. Understanding the accounting treatment for each party is crucial for complying with the new standards.

Lessees are the entities that obtain the right to use an asset through a lease agreement. Under the new lease accounting standards, lessees are required to recognize a lease liability and a corresponding right-of-use asset on their balance sheets for most leases. These changes bring more transparency as to the financial obligations and assets associated with leases.

On the other hand, lessors are the entities that grant the right to use an asset through a lease agreement. The accounting treatment for lessors may vary depending on factors such as the lease term, classification, and collectibility of lease payments. Lessors generally continue to classify leases as operating leases, finance leases, or sales-type leases.

Lease Accounting Terminology Definitions

To accurately account for leases, various calculations and measurements need to be understood. Here are some key definitions commonly used in lease accounting:

Lease Term

The non-cancellable period for which a lessee has the right to use an asset, including both the initial term and any extension options that are reasonably certain to be exercised.

Operating Lease

An operating lease is an agreement where the owner (the lessor) allows another party (the lessee) to use an asset for a duration shorter than its economic life without transferring ownership. In exchange, the lessee makes regular payments for the agreed lease period. 

Finance Lease

A finance lease is an agreement where the owner (the lessor) permits a lessee to use and control an asset for an extended period, in return for lease payments. In this type of lease, the lessee takes on many of the economic benefits and risks associated with ownership of the asset. At the end of the lease term, the lease transfers ownership to the lessee.

Lease Liability

The present value of lease payments that a lessee is obligated to make throughout the lease term. It represents the lessee’s obligation to make future lease payments to the lessor.

Right-of-Use Asset

An asset that represents a lessee’s right to use a leased asset during the lease term. It is calculated as the initial lease liability plus any lease payments made before the lease commencement date, lease incentives received, and initial direct costs.

Discount Rate or Interest Rate

The rate used to calculate the present value of lease payments. It is typically the lessee’s incremental borrowing rate or the rate implicit in the lease, if known.

Straight Line Expense

Straight-line rent expense mandates lessees to evenly spread their total lease liability as expenses throughout the lease term. Just like straight-line depreciation for fixed assets, this method ensures consistent recognition of expenses over time. It’s calculated by summing all rent payments and dividing them by the entire contract duration.

Lease Payments

The consideration specified in the lease agreement, including fixed payments, variable payments, and certain amounts expected to be paid by the lessee.

Understanding these definitions is essential for accurately measuring and recording lease-related transactions for accounting purposes.

Lease Accounting Calculations & Concepts

Present Value Calculations

Present value represents the current worth of future lease payments. To calculate a lease liability, companies discount future payments using the rate implicit in the lease. If this rate isn’t available, the incremental borrowing rate is used. For example, if lease payments are $1,000 per month for 5 years, the monthly incremental borrowing rate is 5%, and the present value factor at 5% for 5 years is 55.84, the present value of the lease liability would be $55,840 ($1,000 x 12 months x 55.84). Understanding net present value is crucial for properly recording lease assets and liabilities.

Lease Amortization Schedule

For financial reporting, the lease liability and right-of-use asset must be amortized over the lease term. This involves allocating expenses to each period in a rational, systematic manner. For the lease liability, companies recognize interest expense each period using the effective interest method. The right-of-use asset is amortized on a straight-line basis unless another method better represents the asset’s use. Creating a full amortization schedule allows accurate recording of lease costs and asset balances each period.

Lease Accounting Memo

In order to properly adopt new lease standards, companies should document key accounting policy decisions in a lease accounting memo. This includes the discount rate policy, lease term assessment guidelines, threshold for capitalization, separation of lease and non-lease components, and more. Documenting decisions provides justification if needed and serves as an accounting manual when accounting for new leases.

Lease Accounting Audit Prep

The implementation of major new lease accounting standards significantly impacts financial reporting and the audit process. 

Companies need to ensure they are well-prepared for the audit process under the new standards such as ASC 842 and IFRS 16. To set themselves up for a smooth audit, companies should maintain organized lease schedules and amortization tables that tie back to the original contracts and terms. Auditors will be checking the accuracy of these details. Companies also need to retain documentation around key estimates and judgments made, like determining incremental borrowing rates and assessing lease terms.

It’s important to perform periodic reviews of the lease portfolio throughout the year for modifications, remeasurements, impairments or other changes. Strong controls and review processes should be implemented over lease data collection, calculations, journal entries, and reporting. Running parallel tests and dry runs of the new lease adoption provides an opportunity to assess impacts to financial statements, financial ratios, cash flow statements, income statements and disclosures well in advance of implementation.

Quick Tips on Building Lease Audit Processes:

• Maintain organized lease schedules and amortization tables. Auditors will check details back to original contracts.
• Retain documentation around key estimates like discount rates and lease term assessments. Be prepared to explain significant judgments.
• Perform periodic reviews of leases for modifications, remeasurements, impairments, or changes in term
• Implement strong controls and review processes over data collection, lease inputs, and accounting calculations.
• Assess the impact to financial statements and disclosures.
• Plan for audit timing, resource needs, and documentation requests. Proactively communicate with auditors in advance.

Organizations will  need to evaluate any required changes to systems, processes, and controls to support the new lease accounting data and requirements. Training should be provided across finance teams and the organization on the new standards and their implications. Taking these steps will enable a smooth audit and demonstrate compliance and understanding of the new lease standards.

Read our blog post on Lease Accounting Audit: Prep, Process, & Reporting for a deep dive on how to prepare and pass your lease accounting audit.

Lease Accounting Software

Given the complexity of lease accounting and the new standards, many companies are turning to lease accounting software solutions to streamline their lease management and accounting processes. These software platforms provide user-friendly interfaces and collaborative features, allowing commercial tenants, CPAs, and real estate teams to efficiently track real estate or equipment data, calculate company performance, and report lease-related assets.

Some key features to look for in lease accounting software include:

1. Lease data centralization: The software should enable the centralization of lease data, including lease agreements, terms, and financial information, making it easily accessible and manageable.
2. Lease classification and measurement: The software should facilitate the accurate classification and measurement of leases based on the applicable accounting standards.
3. Lease payment tracking: It should provide tools to track and manage lease payments, including fixed payments, variable payments, and lease modifications.
4. Reporting and compliance: The software should generate comprehensive reports and financial statements that comply with the new lease accounting standards. It should also support the integration with existing accounting systems to streamline the overall financial reporting process.
5. Collaborative Workflows: Ensure your lease accounting software feeds into your real estate teams’ techstack, enabling transparency across the entire lease lifecycle from deal tracking to lease management and lease accounting compliance.

By leveraging lease accounting software, companies can improve accuracy, enhance compliance, and reduce the administrative burden associated with lease accounting.