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One of the most significant changes coming in 2023 with ASC 842 is what type of leases appear on the balance sheet. Between operating leases, capital leases and finance leases, there are a lot of ducks to keep in a row.
Under ASC 840, operating leases and finance leases (formally capital leases) were not reported on the balance sheet in the same way. Operating leases were once buried in the footnotes but, for private companies, they will soon be included in the balance sheet alongside finance leases
What makes these lease types different, how do you know what lease is what type, and how does a busy lease accountant manage all of them?
Accounting for Finance Leases
When it comes to a finance lease, at least one of these four criteria must be met:
1. The term of the lease is greater than or equal to 75% of the useful economic life of the asset.
2. The present value of the lease rental is more than 90% of the fair value at the time of the lease.
3. A transfer of ownership exists.
4. A bargain purchase option exists.
As a result of these four criteria and with capital assets and liability recorded, expenses are recorded as interest and depreciation.
Under ASC 840, finance leases required specific data points for accounting calculations. Data points include:
- Lease possession date
- Lease expiration
- Option dates and an assessment if the option is reasonably certain to be exercised
- Rent payment amounts
- The company’s incremental borrowing rate
However, for private companies starting the new year under the latest standard, those data points are needed for virtually every lease.
Accounting for Capital Leases
As we know by now, in 2016 the Financial Accounting Standards Board (FASB) amended its accounting rules. They chose to change the term capital lease to finance lease. The goal of the name change was to better align FASB standards with the International Financial Reporting Standards (IFRS).
Many American lease accountants still colloquially use the term “capital lease” but finance lease is the correct term in ASC 842 reporting
Companies that operate beyond one country’s borders can now tidily keep track of their leases without switching back and forth between two names for one type of lease.
Accounting for Operating Leases
Similarly, operating leases have four classification criteria:
1. The lessor retains ownership during and after the lease term.
2. The lease cannot offer a bargain purchase option at the end of the term.
3. The lease term is less than 75% of the estimated economic life of the asset.
4. The lessee uses less than 90% of the useful life of the asset.
The result here is that rent expenses are recorded on a straight-line basis when accounting for an operating lease.
Historically, the overwhelming majority of leases have been operating leases. For a long time, those leases remained buried in the footnotes rather than appearing on the balance sheet. ASC 842 will change that in the reporting done by private companies.
Which is which?
We know now that all lease contracts with terms longer than one year will be added to financial statements. It’s been estimated that trillions of dollars will be moved to the balance sheet because now almost every lease will need to have a corresponding Right of Use (ROU) Asset and Lease Liability, regardless of classification type.
We also know that capital leases and finance leases are the same thing. But, like cookies and biscuits, they have different names in different countries.
The differences appear in the criteria. Ownership, purchase options, estimated useful life of the asset, lease term and lessee usage all combine to determine whether you have an operating lease or a finance lease.
How to Manage Multiple Lease Types
Don’t try to take it on alone.
An intelligent, advanced lease accounting solution can be the best coworker you’ve ever had. You need a system that will analyze and classify leases for new lease accounting requirements. You need a system that generates journal entries, calculates percentage rent obligations, integrates with existing accounting systems and is capable enough to run parallel reporting under old and new accounting standards.
Choosing a comprehensive, proven lease accounting, lease management and lease administration software allows you to manage leases in the manner that best suits your company and meets the new ASC 842 guidelines.