What is lease accounting?
Lease accounting is the method by which organizations account for their leasing contracts – whether lessors or lessees – on their balance sheets. The reporting standards for lease accounting are maintained by the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) internationally.
That’s the short version of the definition of lease accounting. But after the release of ASC 842 and IFRS 16 in 2016, there’s a whole lot more to it. One of the major changes with the new standards is that lessees must capitalize most of their leases.
To do that, you need to calculate the present value of those leases. And this is leading to a major misconception that the new standards can be boiled down to a simple calculation: net present value. That’s the starting point, but there’s much, much more to ASC 842 and IFRS 16.
What do the new standards really require of you?
The impetus behind the standard change was to enhance transparency into financial obligations. Leases have long been a blind spot in that category. ASC 842 and IFRS 16 require companies to bring most leases onto the balance sheet. But before you begin preparing your financial reports, you need to get a deeper understanding of what the standards call for.
Beyond present value: a closer look at lease accounting calculations
There is a complex set of calculations you have to complete in order to be fully compliant. Beyond net present value, you also need to calculate:
- Lease liability amortization schedule
- Right of use asset amortization
- Straight line rent expense
- Amortize right of use asset and liability balances over the lease term
- This is driven by the discount rate, which you can learn more about here
- Liability reduction
- Asset lease expense
- Weighted average discount rates for operating leases
- Weighted average lease term for operating leases
- Weighted average discount rates for finance leases
- Weighted average lease term for finance leases
And this list barely scratches the surface. For instance, it doesn’t include the necessary disclosures that use these calculations but report on them in different ways.
Decisions you need to make
The new standards require you to do more than just crunch the numbers, because they represent a shift from rules-based accounting to principles-based accounting. That shift means you need to start making judgement calls. It’s one of the mental hurdles you’ll need to overcome in order to comply.
Some of those decisions include:
- Whether you will have a materiality threshold to determine which leases will go on balance sheet
- Whether you will elect practical expedients under ASC 842 or IFRS 16 – some can be elected company-wide, while others can be elected by class of asset
- The method you’ll use to determine discount rate
Don’t miss the opportunity the new standards provide
There is an opportunity to do more than simply comply. Transitioning to the new standards offers you the chance to develop better insights into a variety of key metrics by enabling you to:
- Project costs by reporting location or business segment
- Gauge how the new standards will impact your debt covenants
- Report on your leases based on allocation or segment
- Work more collaboratively with leasing departments to help them perform lease vs buy analyses
The depth of complexity of the new standards can’t be understated. By rethinking the way you look at leases, you have an opportunity to think more critically about how you account for them and their impact on your business.
With so many recent regulation changes – revenue recognition comes to mind – it can be easy to develop regulatory fatigue. But changing the way you think about these new regulations will set you up for compliance in the short term and support your career development in the long term.