Lease accounting can be considered the financial management aspect of lease agreements.
A lease agreement is a type of contract that allows a person or business to give someone else the right to use their equipment, services, or property. In exchange, the lessee will pay a pre-agreed payment amount. Two common lease types are finance leases and operating leases.
Leasing is beneficial to companies as it gives them grace in terms of cash flow, and also has potentially lower upfront costs than one would require for an outright purchase.
With an outright purchase, there is an upfront infusion of cash. With a lease, a set amount of cash is paid to the lessor at predetermined intervals.
Benefits of leasing for the lessee
From the lessee’s standpoint, leasing is beneficial because they enjoy:
- Flexible payment schedules
- Not having leased equipment as a liability on the company’s balance sheet
- The ability to improve equipment, tools, and vehicles by upgrading the items once the initial lease is complete.
- Reduced obsolete tools and equipment because it is easier to replace leased items
Think, for example, of a company that has several vehicles for their employees. If they purchase vehicles brand-new, they would be solely responsible for the upkeep and maintenance of the vehicles and would have the responsibility to sell the vehicles once they reach the end of their service life.
However, with the leasing arrangement, the company always has reliable new cars that are maintained by the dealership for a stipulated monthly payment. The dealership benefits because they can sell like-new vehicles for a profit on top of the money they have made from the lease.
Disadvantages of leasing
As with all business deals, there are also disadvantages for both sides. The lessor has limited control over how and when payments are made. Nor can they control how the items they are leasing are treated. Accountants refer to this lack of control on the part of the lessor as the agency costs of leasing.
Adhering to accounting principles for leasing
Generally Accepted Accounting Principles (GAAP) require companies to identify and evaluate their leases to ensure that they meet model guidelines and that each lease is properly accounted for. Sound tricky? It can be. This is where Netsuite comes in.
NetSuite is a well-known accounting software solution, its lease accounting functionality comes with tools designed to simplify this form of accounting and ensure your business meets the accounting standards for leased items.
Understanding financing vs. operating lease agreements
Operating leases also referred to as capital leases, and financing leases are the two most popular types of leases. To distinguish between the two, you need to understand how much risk and how much reward exists for owning the assets a lessor has given to the lessee.
If there was a full transfer of risks and rewards, this is a financing lease based on International Financial Reporting Standards (IFRS). If there is not a complete transfer of risks and rewards, then it is an operating lease. Common examples of operating leases are the leases between an apartment renter and their landlord.
In order to be a financial lease, the following must be true:
- The lease lasts for most of the useful economic life of the asset, which is typically 75 percent or more.
- A bargain purchase option must exist. This means that the lessee has the option to purchase the item they are leasing at a future date for a reduced price. For example, a person might lease a car for 12 months and then at the end of the 12 months have the option to purchase the vehicle for less than the fair market value. The terms and conditions for this purchase are typically established when the lease is first created.
- Finally, the net present value of minimum lease payments should be at least 90 percent of the asset’s fair value.
In 2016, the FASB (Financial Accounting Standards Board) added criteria. If an asset is so specialized that the lessor has no alternative use for the item once the term of the lease is complete, it is viewed as a finance/capital lease.
Companies that have finance leases record the asset and any liability connected to it on their balance sheet. They can deduct computed compound interest from the lease payments every year on their income statement.
4 important steps in the lease accounting process
It is important to account for leased equipment whether you are the lessor or the lessee, as this greatly impacts your overheads and business taxes submissions. All four of the following steps are required for lease accounting and can be recorded using NetSuite.
- Recording the current value of all lease payments. This is the cost of the lease.
- Recording just the interest portion of payments as an expense.
- Depreciating the recognized cost for the asset through its lifecycle.
- Once the asset is retired, its disposal must be recognized.
Lessor accounting for capital leases
US GAAP requires that the lessor keep track of the capital lease as a direct finance lease if the carrying value and the lease payments are the same amounts. When the current value of the lease payment is higher than the asset-carrying value, the lease will be recorded as a sales-type lease.
In NetSuite lease accounting, the lessor will report both direct finance leases and sales-type leases on their financial statement as:
- Balance Sheet: The lease receivable is reported using the present value of the lease payments
- Income Statement: The interest revenue is recorded based on lease receivables calculated using the interest rate from the beginning of the loan.
- Cash Flow Statement: The interest components will be recorded as operating cash flow and the principal will be recorded as investing cash flow.
Removing the complexity of accounting
You need to keep accurate books whether you are the one leasing your equipment out or the one leasing equipment. It is important to work with an accountant that understands the ins and outs of lease accounting. At Fusion CPA, our team of experienced accountants, bookkeepers, and financial advisors can help you understand the benefits of leasing for your business and help you account for it accurately. We can also set up your lease accounting software to help you remain compliant. NetSuite is just one of many accounting tools that we have at our disposal.
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