Lease Accounting Standards

Lease accounting standards refer to a set of appropriate accounting principles and policies applicable to the different leases recorded in the financial statements. The goal of these standards is to help improve lease transactions' transparency and accountability throughout the business.

There are multiple standards established for the regulation of leases globally. Some of the popular ones include AS 19, IAS 17, GASB 87, ASC 842 and IFRS 16 lease accounting standards. They detail the right of use asset and accounting practices required from the lessee and lessor's side. 

Lease accounting standards are established accounting methods required to be followed when recording lease-related transactions in the books. Its sole significance is to prescribe lessee and lessor how to record leases appropriately and account for the same. In addition, the new lease accounting standards also detail the disclosures for financial and operating leases. Information on lease liability also applies to the concerned parties (lessor and lessee). However, it depends on the type of standards, party, and type of lease.

While considering the recent lease accounting standards changes, the lease treatment also differs. Technically, there are two types, namely operating and financial leases. When the person transfers all the risks and rewards related to the asset ownership to the other party, it is known as a financial lease. Any other lease except financial acts as an operating lease. 

While recording them, factors like lease tenure, asset type and its nature, agreed price and payment terms are taken into consideration. Following is the accounting treatment for these leases:

#1 - Lessor

• In the case of a financial lease, the lessor may record assets at the amount equal to net investment as mentioned in the lease agreement. 
• It is necessary to record any financial income arising from the leased asset in a consistent pattern noticeable in the rate of return. 
• If there is any reduction in the estimated residual value of a lease asset, allocate the rest income to the remaining term. Similarly, the initial direct cost can be immediately recorded in the income statement and spread over the lease term. 
• For operational leases, the lessor may record assets under fixed assets in the balance sheet. Likewise, income or cost incurred as depreciation resides in the P&L account. 

#2 - Lessee

• In a financial lease, the lessee will record the lease as assets or liability and then record it at an amount equal to the fair value of lease assets. 
• Any lease payment must be categorized as a finance charge and reduction in outstanding liability. 
• Allocate the finance charge over the lease term and pass journal entry for depreciation. 
• For the operating lease, the finance charge will act as an expense in the P&L account. 

Globally, there are multiple standards followed in the accounting process for leases. However, the popular ones include IAS 17, AS 19, ASC 842 and IFRS 16 lease accounting standards. Let us understand them in brief:

#1 - IAS 17

It applies to all leased assets except for minerals, oil, natural gas, and akin regenerative resources. It also excludes licensing agreements for films, plays, manuscripts, patents, videos, copyrights, and similar items. Even biological assets held under operational and financial leases and property held by lessee also act as investment property under IAS 40 (fair value model). It is similar to the AS (Accounting Standards) 19 but is different. While IAS (International Accounting Standards) 17 is applicable to the lease of lands and buildings, AS 19 denies such. Also, IAS 17 recognizes the adjustment of lease payments.

In the case of a financial lease, if the lessee cancels the agreement, the lessor's losses are borne by the lessee. Similarly, any fluctuations in the fair value reside with the lessee. However, one benefit for the lessee is that they can continue the lease term at a rent lower than the market rate. For accounting purposes, the depreciation policy remains consistent for all owned assets. Likewise, at the start of the term, the asset value must be recorded as lower than the fair value and the present value of the lease payments, whichever is minimum.

#2 - ASC 842

It is a new lease accounting standard update followed in the United States. This standard requires leases to appear in the balance sheet as right for use and liability. Additionally, it requires the disclosure of a company's leased assets, the categorization of leases as either finance or operating, and reporting of the leases' monetary values. 

#3 - IFRS 16

The International Financial Reporting Standards (IFRS) 16 does share some common traits with ASC 842. However, this model allows a single accounting model for leases and enables recording lease assets and liabilities for more than 12 months. 

Let us look at some examples of lease accounting standards for a comprehensive understanding of their application in general:

Example #1

Suppose Samuel owns land which he decides to put on lease for additional income source. Luckily, John agrees to take his land at an agreed amount of $130000 for 14 months at an initial term. As months passed by, Samuel recorded the rent in the P&L account as lease income. Any costs occurring in the maintenance were also recorded in the same statement. After 14 months, the lease agreement came to an end, but John wished to continue with the lease. Thus, on mutual agreement, Samuel decided to further the lease by 1.5 years and the rent payable by John was 10% lower than the market rates. 

Example #2

According to a news article, as of March 2024, the UK Financial Reporting Council (FRC) has proposed some improvements to the existing financial accounting standards. However, the most significant ones included the leases and revenue recognition for better presentation of financial information to the stakeholders. Additionally, it has revised and restated the recognition exemption for leases of low-value assets. It will further provide the most accurate and significant leases on the balance sheet. 

The changes in lease accounting standards have a huge impact on the businesses and parties involved. One of the prime impacts is seen on the liabilities side. Since the lessee takes the property on a lease basis, the future payments act as a liability. Similarly, it also impacts the financial metrics and ratios like debt-to-equity, return on assets (ROA), and debt-to-assets. They are likely to increase the weightage of liabilities in the balance sheet. 

Additionally, right-of-use (ROU) assets allow organizations to use the asset for a term. However, the ROU gradually slows down with the expiry of the lease agreement. There are positive impacts of these standards as well. They promote transparency, accountability, and consistency when recording and reporting lease transactions. Even stakeholders find understanding the organization's financial risk and stability easier. Also, financial analysts and management can take wiser investment decisions considering the existing lease liability or assets undertaken.