What is Lease Accounting?
Lease accounting is a type of accounting that focuses on the leases you have in your business. Certain types of lease classifications have to go on your financial records along with things such as employee benefits plans. You have to record an operating lease or finance lease whether you're the lessor or lessee. Both parties must track the lease payments until the end of the lease. This can help you maintain accurate records of the remaining economic life of the loan. Private companies can keep an eye on the initial direct costs and other costs the lease involves.
Why It Matters
Lease accounting helps you gain business insights regarding your overall finances. Leases can take up a lot of your working capital, so you need to account for them on your balance sheets and other financial statements. Whether you make fixed or variable lease payments, you should track everything throughout the lease term. Then you can understand the present value as well as the useful economic life of your leases. You'll also be able to calculate the total lease cost for the life of the term. Tracking leases is crucial for both lessee accounting and lessor accounting to track residual value and other leasing activities.
What Is ASC 842 Lease Accounting?
ASC 842 is the lease accounting standard for private and public business entities. The ASC 842 become effective for public companies in 2019 and recently became effective for private companies in 2021.
What Counts as a Lease Under ASC 842?
- The new guidance under ASC 842 defines a lease as a contract that grants control of an underlying asset. The lessee model requires the borrower to pay the lessor. Whether the lease is for office space or it's a sales type lease, the new lease accounting standards cover more things. So even if you weren't tracking certain entities before, you may need to start. This applies whether you have a capital lease or an operating lease.
What Are the Goals of ASC 842?
- The goals of the new lease accounting standards include getting more transactions on the balance sheet. That way an owner or managing director can have better financial reporting. Better reporting also helps make records more transparent, which can help you understand the initial direct costs and the interest rate. You can also determine the fair value of the lease when looking at a purchase option.
- These new lease accounting standards also help with capital allocation. You can determine if a direct financing lease is right for you, for example, when setting up a lease agreement, you'll know if it's an operating lease or finance lease. Then, you can know whether you need to track the underlying asset or not.
Transitioning to the ASC 842 Standard
- The transition to ASC 842 will make it easier for certain entities to keep track of one or more payments on leases. That way, you can understand the financial impacts of your leases. Consider how these accounting standards can affect member firms and clients.
Complying to the ASC 842 Standard
- As you set up your lease agreement, you should consider how new standards affect it. You don't need to report short term operating leases on your balance sheet. However, if you have financing leases or operating leases with a long lease term, those should go on your balance sheet. Software can help you keep track of various leases, regardless of when they start. That way, you won't have to track ASC 842 manually, which can take time. The standard has a lot of requirements that can be almost impossible to comply with if you don't take advantage of the right software.
Types of Leases
When setting up new lease accounting systems, you must consider different types of lease classifications.
Leases with minimum lease payments that will not lead toward ownership of the underlying asset. You only have to track these on a balance sheet if the lease is longer than 12 months. If you have leases for interim periods, you won't need to worry about reporting them.
Also called capital leases, are for a lease asset you can eventually own. When you're the lessor, you can track the selling profit as you lease out the item if the borrower wants to buy it. Private and public companies should consider the lease classification. That way, both parties can track the lease arrangement and any other details.
How Do You Record a Lease in Accounting?
Whether you're tracking a finance lease or operating lease, you can record the transaction. The process is similar to other transactions, especially if you already use double-entry accounting. When you write a journal entry, you'll track the assets and liabilities as they relate to the lease and lease term. As you record minimum lease payments, you can view the economic life of the lease. Be sure to start creating entries from the commencement date until the end of the lease. Doing this can help you track the readily determinable fair value on your balance sheet.
What Are the Leasing Accounting Steps?
Another essential part of understanding lease accounting is knowing how to implement it. Whether you have a capital lease or operating lease, or a mix of both, you'll need to track them on your balance sheet. Accounting for a lease helps you understand the present value of the asset, regardless of lease classifications. You'll need to track everything from the value to the incremental borrowing rate. That way, you can keep track of what you owe as a lessee or how much you'll get as a lessor. You can also track the progress toward the purchase if you go with a bargain purchase option.
Differentiate the Accounts
First, you'll need to understand the lease liability and the right of use asset. You can calculate these each day to get the present value of the lease. The lease liability tells you how much the lessee will pay for future lease payments. Meanwhile, right of use assets determine the borrower's right to use the leased asset. You will create an entry for both numbers at the start of the lease and regularly until the end of the lease. The right of use asset will show up as a debit transaction, while lease liability will be a credit transaction on the balance sheet.
Outline Amortization and Lease Liability
Whenever you do lease accounting, you'll need to report amortization and lease liability for the loan. You can note amortization when you pay off the principal and the interest or incremental borrowing rate. Be sure to track lease liability in the form of interest on your balance sheet. You may need to track these as different transactions and entries, depending on when they occur. Amortization will decrease the right of use asset, whether in a straight line basis or otherwise, while making payments can increase the lease liability. Accounting for both of these details helps you get the full picture of the present value of your capital lease.
Record Journal Entries Regularly
You'll need to record these transactions as journal entries for the length of the lease term. Reporting transactions monthly can help you stay on top of payments, and you can keep track of the fair value of the lease. You can also keep track of various lease terms if you have a financing lease and multiple operating leases, for example. As you make payments, you should see the right of use asset and lease liability go down. Eventually, those values will be at zero on your balance sheet. After you pay a significant portion of the lease, you can track your progress toward the end of the lease or ownership in the case of a purchase option.
Some capital leases or operating leases may require modifications. This can happen if you adjust something regarding the scope, and the original lease agreement didn't account for that If you have a modification, you'll need to remeasure the lease liability and right of use asset. When you modify the lease, you'll need to create a new journal entry to mark the change. Noting the change is essential, especially if it affects the residual value or fair value of the lease. The entry can also ensure future lease payments reflect the new present value.
Why Use Lease Accounting Software?
The specialized nature of lease accounting means you should consider using specific software. You can use the same general accounting software or spreadsheets to track operating leases. However, software that lets you track a lease offers many benefits. Whether you have a small business with one lease or a massive corporation with dozens, consider how the right program can help. With a solution like iLeasePro, you'll be able to track all of your capital leases and operating leases.
Summarize Key Lease Data
If you have multiple leases, it can take a lot of time to track all of your lease payments, lease incentives, and other data. You may use a spreadsheet for each leased asset you have, but consider how many leases you have. Specialized software can help you view a summary of all of your financial transactions. Then, you can see if leases are taking up a huge part of your profit and budget. You may not need this if you have a small business with one lease. However, as your business grows, software can track and summarize everything for you so that you can save time. Then, you can make sure you keep up with lease payments. And you'll know when operating leases end so that you can return the leased asset on time or renew your lease.
Work With Journal Entry Software
If you use journal entry software, you can integrate it with a lease accounting program. Creating journal entries that meet the requirements of common programs can be difficult. You may need to spend a lot of time verifying transactions to create a journal entry. Fortunately, accounting programs that work with leases can simplify the process. Once you set up your lease accounting program, you can automate the journal entry process. All you'll have to do is verify the numbers on each entry to track the right of use asset and lease liability. This can help you avoid making mistakes when doing your accounting at the end of the month.
Easy to Access and Use
Another advantage of software is that you can use a cloud-based program. The cloud makes it easy to access and use your program of choice from anywhere and with any device. If you need to check on capital leases when you're out of the office, you'll be able to do so. Of course, you can store spreadsheets in the cloud for easy access, and you have alternative use options to make the most of your spreadsheets. However, those files don't have the other benefits of automation. If you want something that's easy to use, cloud-based software is an excellent choice.
Avoid Team-Related Issues
If you use spreadsheets to track leases, you can easily have duplicate files and other issues. This is particularly true for teams who work on the leases and their finances. One person might copy the file to experiment with the formulas. Another person may accidentally delete vital information, such as lease payments, from the main spreadsheet for a leased asset. You can't track changes that easily, and it can be hard to get data back after it goes away. Fortunately, the right lease tracking software can help you avoid those problems.
Lease Accounting Made Easy
Do you struggle with lease accounting in your business? Before you give up, consider how the process works and how you can make things easier on yourself. Then, you'll be able to keep track of your various leases and payments. Soon enough, you'll look forward to financial reporting for all of your operating and financing leases. iLeasePro offers an uncomplicated approach to lease accounting and lease management for lessees of real estate and equipment leases. View our pricing and Schedule A Demo Now to learn more.