What is Lease Accounting? The basics simplified and explained
Effective from 1st January 2019, IFRS 16 are the new standards for lease accounting issued by the International Accounting Standards Board (IASB). These latest requirements for lease accounting are designed to deliver additional asset transparency and offer a comprehensive model for lessee and lessor accounting, covering existing, new and future leases.
Under the new rules, operating leases have to be reclassified and accounted for on the balance sheet with the notable exceptions being short term leases (generally with lease terms less than 12 months) and leases for low-value assets.
In this blog, we aim to explore what is lease accounting, why it is important and the advantages and opportunities of adopting the new standards.
What is Lease Accounting?
Lease accounting refers to the process of recording the financial activities and impact of leasing arrangements for a company. This includes cash flow statements, income statements and balance sheets as they relate to the lease expenditure or income.
Lease accounting is required by those who lease assets as well as businesses who act as the lessor, with the key objective of providing a clear picture of the financial health of the business, including current asset worth, liabilities and so on. Lease accounting software is commonly used to ensure compliance with IFRS 16 requirements and to make life significantly easier by automating calculations which are otherwise time-consuming, prone to error and difficult to audit in a spreadsheet or separate software approach.
Lease accounting key terms and definitions
Below we look at some of the key IFRS 16 and lease accounting terms and what they mean:
Lease: An agreement between the owner of an asset and another party who wishes to use that asset. A lease defines the term of use for the asset, and the financial compensation paid to the owner in return for that use. There are two types of leases, operating and financial.
Lessor: This is the person or organisation who own an asset that is offered for lease. From property to vehicles, equipment or even intangibles such as a brand can be offered for lease by the legitimate owner of an asset.
Lessee: The individual or organisation who takes up a lease on a given asset. The lease defines how long they can use the asset, in what way they can use it, and of course, how they pay for the use of the asset during the lease. In some cases, lessors may also offer an opportunity to purchase the asset at the end of the lease.
Right of Use: The right-of-use asset is a lessee’s right to use an asset over the life of a lease.
Lease liability: The lease liability represents the financial obligation for lease payments and is measured by calculating the present value of future lease payments.
Why is lease accounting important?
Lease accounting provides a clear view of a business’s financial situation taking into account the impact of any leases they are involved with. It reveals risk levels and highlights the effect of leases on the balance sheet, making it an indispensable tool for investors as well as lessor and lessee leadership.
Understanding liabilities, assets, income and expenses is always essential for any business, but with lease accounting, all those factors are placed in context with the leases held, which gives a much clearer understanding of the true and current financial situation.
Accounting reports that do not consider leases can portray a very different picture, ignoring significant liabilities such as long lease payments when presenting the financial health of an organisation. However, those lease payments will always need to be paid, so must be part of the overall financial health of the business which IFRS 16 lease accounting achieves.
5 advantages of the new lease accounting standards
Whilst the introduction of the new IFRS 16 lease accounting standards has posed significant challenges for many businesses, they do also bring a range of benefits for both lessors and lessees, as well as potential investors in any business involved with leases. Below are 5 ways in which they offer advantages over the previous accounting standards:
Simplified audit process and audit trail
Dealing with auditor requests is both time consuming and a sure way to cause stress, but the new lease accounting standards go a long way to eliminating the problem. Lease accounting compliance is much easier to administer under the new standards, streamlining the audit process and reducing administration costs as a result.
The new standards for lease accounting mean that all assets are clearly identified and itemised, giving much clearer insight into liabilities and so on. It also provides a comprehensive reference of all resources an organisation has access to, making both resource allocation and procurement much more effective.
Ultimately, this also offers the scope to combine assets into a portfolio, which is allowed as long as there are no financial benefits for doing so. It does make management much easier though.
Integration with existing systems
Lease accounting processes now align with other standards and allows for integration with other accounting systems. The result is, as with auditing, a simplified solution that provides more detail while creating a more efficient approach. Lease accounting software solutions can integrate with existing financial systems to unlock the data and analysis that not only fulfills accounting needs but provides exceptional insight into overall business health.
Asset and liability accuracy
One of the major benefits of the new standards is to reveal hidden costs. By ensuring that all aspects of active leases are taken into account, whether that be lessee’s liabilities or lessor’s assets, accounting reports provide accurate assessment of the true financial situation for any organisation.
Because the new standards for lease accounting take into account all aspects of the lease, they provide a clearer understanding of the current financial situation, as well as the impact of ongoing liabilities. This in turn ensures that forecasting and scenario projections can incorporate those impacts and offer a more reliable look at future performance.
Lease Accounting FAQs
Understandably, there are many questions which have arisen as a result of the new changes and we consider some of those questions below.
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This depends on the type of lease. An operating lease is considered as an operating expense, similar to the rental of an asset. Lease payments are shown as a liability in the accounts of the lessee and as an asset for the lessor.
However, a capital lease, often called a financial lease, is treated as a loan, in this case a long-term loan. Here, the asset value is recorded on the balance sheet of the lessee, including depreciation, and the cost of the lease recorded as a debt.
For a lessee, an operational lease is a liability, with the associated asset not recorded within the accounts. However, in the case of a capital lease, where the asset is recorded and the lease cost recorded as a debt, lease accounting considers it both an asset and a liability simultaneously.
On the initial date of the start of a lease, the company debit right of use for the asset and credit lease liability for the total (minimum allowed) lease payments.
Lease accounting provides clarity when assessing the financial health of any organisation, as it takes into account the assets and liabilities associated with lease commitments that otherwise remain off-book. For business leaders looking to make crucial decisions about future strategy, as well as investors seeking to understand a business’s financial situation, lease accounting is an invaluable tool.
For businesses today, lease accounting software is an essential tool in ensuring the accounting compliance required, while also streamlining the process and ensuring easy access to valuable data that is essential when forward planning.
IFRS 16 Lease Accounting for the Public Sector
On 1st April 2022, the long awaited IFRS 16 lease accounting requirements came into effect for Central Government and NHS organisations, who are now under increasing pressure to fully transition by this 2022/23 year-end. Whilst the transition date fo