The Lease Accounting Standards Guide: Best Practices, Software & More

Why is Lease Accounting Important?

Lease accounting has become a major focus area for public and private companies, audit firms, and consultants because of a new lease accounting standard – ASC 842 – released by the Financial Accounting Standards Board (FASB) in the US, along with IFRS 16 internationally released by the International Accounting Standards Board (IASB), and GASB 87 for government entities. 

Operating Lease vs. Financial Lease – What are the Differences in Lease Classifications?

Whereas in the past, a finance lease was presented on the balance sheet while an operating lease could be expensed through the income statement, with the introduction of ASC 842, IFRS 16, and GASB 87, all types of leases are now presented on the balance sheet.

In terms of whether a lease is a finance lease or an operating lease under ASC 842, the standard sets out specific criteria that need to be met for the lease to be classified as a finance lease. Note that only one of these criteria needs to be met for the lease to be classified as a finance lease.

What are the New Lease Accounting Standards?

There are three new lease accounting standards: IFRS 16, GASB 87, and ASC 842.

Summary of ASC 842

In summary, ASC 842 requires that leases be recognized on the balance sheet as a liability and a right-of-use asset.

The lease liability is the total present value of pending payments, using the discount rate as specified in the standard.

Lease Liability = total value of payments x discount rate

The asset is calculated as the initial liability, plus any initial direct costs and payments before commencement, subtracting any incentives.

Right-of-use Asset Value = Initial liability + Initial direct costs + Payments before commencement – Incentives

ASC 842 also provides guidance around, among other issues, lease modifications, and presentation and disclosure. 

Summary of IFRS 16

IFRS 16 shares many of the same attributes as ASC 842. There are, however, some key differences: 

1. Transition approach and comparatives

IFRS 16 provides a choice: either restate comparatives under the “retrospective approach”; or without restating comparatives under the “modified retrospective approach”.

ASC 842 only allows a modified retrospective approach. However, ASC 842 provides a choice of the transition date. Entities can elect whether the date of initial application is the beginning of the earliest period presented or the beginning of the period of adoption.

There are also some differences relating to the initial application measurement of the right of use asset and transition practical expedients.

2. Leases recognized on the balance sheet

The major difference here is that for IFRS 16, an exemption is offered for “low-value” leases (under $5,000 when new, even if they are material in aggregate). No such exemption is available under ASC 842. 

3. Lease classification

Here is another big difference between IFRS 16 and ASC 842 for lessees: unlike ASC 842, IFRS 16 does not separate finance and operating leases – rather all leases (except for low-value and short-term leases) are considered finance leases, as a single lease accounting model for lessees. 

Under ASC 842 lessee operating contracts are expensed the same way they always have — as a single-line item operating expense, and as operating activity in the statement of cash flows. 

While under IFRS 16 all lessee contracts (except for low-value and short term leases) are expensed to interest expense and depreciation expense, increasing EBITDA; and the lease payments are split into principal payments presented in financing activities in the statement of cash flows, and interest payments that are presented either in operating activities or financing activities in the statement of cash flows in accordance with IAS 7, Statement of Cash Flows.

For lessors, ASC 842 separates contracts into three categories: Operating lease, Sales-type lease, and Direct financing lease. IFRS 16 separates lessor contracts into two categories: Operating lease, and Finance lease. 

4. Remeasurement 

Under IFRS 16, subsequent changes to lease payments that vary with an index or rate require a remeasurement of the lease liability with a corresponding charge to the right-of-use asset. 

Under ASC 842, such changes do not necessitate a remeasurement (unless a triggering event occurs), rather the linking differences are recognized when incurred as “variable payments”. So the liability under IFRS could grow significantly than under ASC 842. Dual reporters will have to separately track the accounting under each accounting standard.

5. Sale and leaseback transactions

IFRS 16 is a lot more definitive in this aspect. The key test is whether there is a substantive option to repurchase the asset in question. If this is the case, the transfer is not recognized as a sale. IFRS 16 limits the recognition of gains from sale and leaseback transactions.

Under ASC 842, this may be considered a sale in certain circumstances, and the seller-lessee would recognize the full gain from a sale and leaseback transaction that qualifies as a sale.

6. Subleases

Under ASC 842, a sublessor classifies a sublease by referencing the underlying asset; while in IFRS 16, the sublessor generally classifies a sublease by referencing the right-of-use asset. 

Therefore there can be cases where a sublease is classified as an operating lease under ASC 842 and as a finance lease under IFRS 16.

Summary of GASB 87

Similarly to ASC 842 and IFRS 16, GASB 87 can be summarized as follows:

Unless the lease is a short-term lease or the transfer of ownership of the underlying asset occurs, a lessee should recognize a separate lease liability and lease asset at the start of the lease term. 

Lease liability: the present value of payments expected to be made over the lease term, net of lease incentives. 

As payments are made, the lessee decreases the lease liability and recognizes an interest expense.

Lease asset: the initial measurement of the lease liability above, plus any payments made to the lessor at or prior to the start of the lease term. 

The lease asset is amortized over the lease term or the useful life of the underlying asset, whichever is shorter. 

Disclosure: include a description of leasing arrangements, the amount of lease assets recognized, and a schedule of future lease payments.

Lessee vs. Lessor Under ASC 842

Below we explore the differences in lease accounting for lessees and lessors.

Lease Accounting for a Lessee

For lessees, the changes of ASC 842 were more wide-ranging. Significant and fundamental changes had to occur, for example, no longer expensing leases through the income statement, but raising new assets and liabilities on the balance sheet – as well as more rigorous disclosure requirements. Essentially, accounting for lessees involves the following:

Recognition

At the commencement date, a new asset and a liability are recognized; specifically, these are a right-of-use asset and a lease liability.

Initial measurement

The standard dictates that the lease liability is measured at the present value of all upcoming lease payments, using the discount rate of the lease. The discount rate to use is itself a topic of discussion. The discount rate is the “rate implicit in the lease” – if this is difficult to determine, the company’s incremental borrowing rate can be used. 

The right-of-use asset is initially measured, at commencement date, as the amount of the lease liability, any lease payments made (net of lease incentives received), and certain direct costs incurred. 

Subsequent measurement

Subsequent measurement is as follows:

For the lease liability: this is the present value of lease payments outstanding, discounted using the discount rate for the lease. 

For the right-of-use asset: to calculate this figure, first start with the lease liability. Then adjust this for prepaid or accrued lease payments, any other lease incentives received, unamortized initial direct costs, and any impairment for the asset. The right-of-use asset should be amortized on a straight-line basis (in most circumstances), and tested for impairment.

Should there be a change in the circumstances of the lease, ASC 842 has specific rules to follow; the Topic also includes examples in this regard. Note that the above is for an operating lease as opposed to a finance lease.

Disclosure

The goal of the disclosure requirements is to give users of the financial statements a comprehensive picture of the company’s lease situation. The disclosure required by ASC 842 from lessees is similar to that of lessors, and includes:

• A company’s leases
• Any significant judgments 
• The amounts in the financial statements relating to leases

Lessees should include: 

• general descriptions of leases
• terms and conditions of variable leases and options to extend or terminate leases
• residual value guarantees
• any restrictions or covenants imposed by lease agreements

Disclosures should also include information about leases that have not yet commenced but that will create significant rights and obligations, along with assumptions made and how the discount rate used was determined. 

Lease Accounting for a Lessor

For lessors, the following are required by ASC 842:

Recognition

Recognition generally relates to three major types of leases for lessors referenced in ASC 842: sales-type leases, direct financing leases, and operating leases. 

For an operating lease, at the commencement date, a lessor must defer initial direct costs. After commencement, a lessor should recognize lease payments as income in profit or loss over the lease term, on a straight-line basis (unless another basis allowed by the Topic is more appropriate.) Should lease payments be variable in nature, these should be recognized in the period in which the factors that are related to the variable nature of the lease occur. 

Initial measurement

For the purposes of initial measurement, lessors should continue measuring the underlying asset as is required by the other relevant topics. 

Subsequent measurement

When it comes to subsequent measurement, lessors should continue to measure the underlying asset in accordance with the other relevant topics – including, for example, by testing for impairment. 

Disclosure

Lessors should disclose both “qualitative and quantitative” information regarding their leases; the level of detail required is largely up to the lessor but is governed by ASC 842 which has many stipulations in terms of what must be disclosed. Disclosures must include:

• The leases themselves
• Significant judgments made
• Amounts recognized in the financial statements that relate to the leases specified

Other information that lessors must disclose is a general description of their leases, the terms and conditions for any variable lease payments, terms relating to options to cancel or extend a lease, and the conditions in which the purchase of the underlying asset is allowed. Other Topics that apply generally to disclosure, apply here; such as any related party information. 

What is Operating Lease Accounting Under ASC 842?

ASC 842 introduced new requirements when it comes to accounting for operating leases. At a high level, these include:

Recognition

Classification: first, the entity must classify each component of the lease at the commencement date. If the criteria for classifying a lease as a finance lease are not met, the lease is classified as an operating lease. 

Lease modifications: lease modifications can lead to accounting for the updated lease as a new, separate lease. ASC 842 outlines the test to determine which treatment should be applied (842-10-25-8). 

Initial Measurement

Lease term: this is the non-cancellable period of the contract that contains a lease or lease element, plus time over which the option to extend the lease is available and it is seen as likely that this option will be exercised; similarly it includes periods where termination is available but is unlikely to be exercised; and finally, periods where the two prior conditions are controlled by the lessor. 

Lease payments: this includes fixed and variable lease payments and is defined in detail in ASC 842 (842-10-30-5). In terms of the rate that should be used, the rate implicit in the lease should be used when available, and if not readily available, then an entity should use its incremental borrowing rate.

Initial direct costs: costs that would have been incurred no matter whether the lease was finalized or not, are not included in initial direct costs. This includes general overheads, advertising, and tax and legal advice. 

Right-of-use asset: This should be measured at the initial measurement of the lease liability, any lease payments made before commencement (net of lease incentives received), and any initial direct costs incurred by the lessee.

Subsequent Measurement

Lease liability and right-of-use asset: the lease liability is measured at the present value of outstanding lease payments; the right-of-use asset is measured using the lease liability amount and then adjusting this for specific elements listed in ASC 842, such as prepaid or accrued lease payments. 

Remeasurement: remeasurement, whether of the lease term or lease payments, occurs when a lease modification as defined has occurred.  

Disclosure

Balance sheet: it’s important to separate operating lease assets and liabilities (classified as current and noncurrent, like all assets and liabilities), or which line items in the balance sheet include the right-of-use assets and lease liabilities. 

Income statement: lessee’s expenses

Cash flow statement: payments resulting from operating leases

General disclosure: The following needs to be disclosed from both a qualitative and quantitative perspective. An entity’s:

• Leases
• Significant judgments made in applying ASC 842
• Amounts recognized in the financial statements relating to its leases

What is a Finance Lease Accounting Under ASC 842?

Under ASC 842, a finance lease needs to meet one of five criteria as set out in 842-10-25-2. These are:

1. Transfer of ownership of the underlying asset at the end of the lease term takes place
2. An option to purchase the underlying asset that is reasonably expected to be exercised is granted by the lease
3. The lease term spans the majority of the remaining economic life of the asset
4. The present value of the lease payments is equal to or greater than the fair value of the underlying asset
5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term

What is Lease Accounting Software? Making Leasing Easier with Automation

Lease accounting software has become mission-critical. Manually dealing with lease accounting has not only become inefficient, it also significantly increases the risk of error and non-compliance, not to mention using up the precious time of you and your team.

Lease accounting software provided by Trullion automates ASC 842 workflows to ensure compliance, eliminate errors and streamline operations in a fraction of the time it would take without Trullion’s game-changing lease accounting software in place.

Using machine learning and AI technology, the Trullion platform automatically extracts data from source documents such as Excel files and PDFs to perform lease analysis. It also simplifies journal entries and creates a clear audit trail that’s accessible to both your internal team and external auditors.

Developed by a team of experienced CPAs and leading product experts with decades of experience, Trullion unifies the unstructured and structured worlds of business finance by using AI to read and understand leases and sales agreements in any format – and translating them into a live 360° data image of your transactional workflow. Trullion establishes a universal language to allow companies to quantify the value of their business, and empowers Accounting Leaders to trust their financial data.

With Trullion’s AI-powered lease accounting software you get:

AI-Powered Data Entry: Using a simplified and automated approach to extract key data points directly from PDF contracts and Excel files to generate the necessary ASC 842-compliant reports with just one click.

Intuitive, Easy to Use UI: Navigate seamlessly through our modern, clean, and easy-to-use interface, built specifically for financial leaders.

Automated Bulk Upload & Modification Detection: Upload any Excel file and the software can detect new, changed, and modified leases.

Streamline ASC 842 Compliance: Automate ASC 842 workflows to generate 100% auditable journal entries and disclosures. Get fully compliant in 30 days or less.

ERP Entries & Dynamic Reporting: Leverage our modern user experience to perform lease analysis, generate ERP-ready journal entries, full disclosure reports, and other business intelligence.

Why You Should Integrate Lease Accounting Software with your Business?

You should integrate lease accounting for the following reasons:

• Seamlessly meet ASC 842 lease standard compliance requirements
• Accelerate your ASC 842 adoption timeline
• Produce 100% accurate and consolidated lease analysis reports in minutes
• Effortlessly trace your audit trail back to the source data
• Access simple reports and clear financial obligation schedules 

What are the Advantages of Using a Lease Accounting Platform?

Advantages of using a lease accounting platform include:

• Leverage modern technology to extract data automatically from PDFs and Excel
• Tag your financial workflows to source data, saving you time and giving your auditors 360º transparency
• Streamline lease accounting compliance
• Automate ASC 842, IFRS 16, or GASB 87 workflows to generate 100% auditable journal entries and disclosures
• Navigate seamlessly through a modern, clean, and easy-to-use interface
• Upload any Excel file and the software can detect new, changed and modified leases
• Generate ERP-ready journal entries, full disclosure reports, and other business intelligence
• Roll-forward reporting
• Interface with your existing ERP system to seamlessly produce journal entries
• Built for financial leaders by-product and accounting experts
• Access collaboration tools to work seamlessly with your team and auditors