Lease Accounting Standards: Compliance and Implications for Lessors.

Overview of lease accounting standards 

In 2019, after a long set of discussions spanning about 10 years, the revised lease accounting standards were introduced by IFRS (for countries following the international standards) and US GAAP (for countries following US GAAP). IFRS 16 and ASC 842 have replaced IAS 17 and ASC 840, respectively. This change was driven by the need to get lessees to report leases on their balance sheet; there has been little impact on accounting for lessors. 

This move aimed to improve transparency and accountability in financial reporting by bringing lease obligations onto lessees’ balance sheets. It is hailed as a significant milestone in standardizing accounting procedures globally.

Classification of Leases

In IFRS 16, there is no distinction between finance leases and operating leases for lessees. Lessors, however, have the liberty of classifying leases into two categories: finance leases and operating leases. On the other hand, ASC 842 introduces an additional category of leases known as sales-type leases, along with operating and finance leases. 

These classifications ensure that lessors can accurately record their lease agreements under the new accounting standards. Understanding these classifications is of the utmost importance for both lessors and lessees to meet reporting requirements and understand the lease’s financial impact. 

Determination of Finance lease for ASC 842

Lease classification for ASC 842 remains similar to ASC 840 with the removal of bright lines. The test of determining whether the lease is classified as finance (earlier capital) or operating is based on : 

• Ownership transfer
• Bargain purchase option
• Major part of the remaining economic life of the underlying asset 
• Substantially all of the fair value of the asset

Additionally, a new test has been introduced for highly specialized assets.

• If the leased asset is specialized or modified at the end of the term, there will be no alternate use there the lessor

Understanding these criteria is essential for accurately classifying leases under ASC 842. If none of these tests are satisfied, the lease is treated as an operating lease; otherwise, it is a finance lease.

Accounting Treatment for Lessors

Depending on the type of lease in question, lessors have to handle their finances differently. Mainly, there are three types of leases: operating leases, financial leases, and sales-type leases. Lessor accounting software is often used to manage various kinds of leases efficiently. Each type requires specific accounting treatment to accurately reflect the financial picture. Knowing how these leases function and how to handle them is of the utmost importance for lessors. Only then can they begin to manage their finances effectively and make informed choices.  Let’s delve into each type to see how they’re handled in accounting practices and lessor accounting software.

Operating leases

There is no difference between ASC 842 and IFRS 16. Lease payments are recognized as lease income on a straight-line basis over the lease term, unless another systematic basis is more representative of the pattern in which benefit is expected to be derived from the user of the underlying asset. 

This approach makes it easier to compare financial statements. Since the process is quite straightforward, the chances of mistakes being made remain low. Plus, using the straight-line method ensures lessors receive a steady income over the lease period.

Finance leases

Under ASC 842, only selling losses resulting from the lease are directly recognized in the income statement. Selling profit and initial direct costs are deferred, included in the measurement of the net investment in the lease, and therefore allocated over the lease term.

Financial leases clearly portray the financial impact of the lease. By allocating costs over the lease term, it provides a more accurate representation of the lessor’s financial position. 

Sales type leases

The accounting for sales-type leases is similar to the requirements of IFRS 16 for manufacturers and dealers, including recognition of revenue, cost of goods sold, and any initial direct costs in the income statement when control of the leased asset transfers to the lessee. 

Key provisions of each standard

Both IFRS 16 and ASC 842 provide lessors with clear guidelines on accounting for leases. These standards dictate how leases are classified on lease accounting software solutions and how income and expenses associated with leases are recognized. All lessors have to adhere to these regulations. Once the lessor understands these key provisions, they can effectively manage their lease portfolio. Let’s take a look at what these guidelines state.

IFRS 16

• A lessor should classify each lease as either a finance lease or an operating lease. Leases that transfer substantially all of the risks and rewards incidental to ownership of the underlying asset are finance leases, all other leases are operating leases.
• A lessor shall recognize assets held under a finance lease as receivable at an amount equal to the net investment in the lease.
• A lessor recognizes finance income over the lease term of a finance lease, based on a pattern reflecting a constant periodic rate of return on the net investment.
• Income is recognized on a straight-line basis for operating leases.

ASC 842

• Lessors should classify leases as sales-type leases, direct finance leases or operating lease.
• For sales-type and direct finance, the lessor should recognize the underlying asset and recognize or defer additional profits and expenses associated with the lease.
• For operating leases, the lessor should defer initial direct costs at the commencement of the lease and recognize lease payments and initial direct costs over the lease term.

Conclusion:

Thus, the introduction of revised lease accounting standards by IFRS 16 and ASC 842 in 2019 sought to enhance transparency in financial reporting. While the lessors were not significantly affected, it became common practice for lessees to report relevant leases on their balance sheet. This practice ensured consistency and reliability in reporting, which in turn fostered trust among the stakeholders.

Overall, the introduction of these norms highlight the importance of transparency and accuracy in financial reporting, ultimately strengthening our confidence in the global financial system.