What Is Lease Accounting and Why Is It Important?

Today, there are more than 44 million rental properties in the United States, and the US apartment rental market is worth upwards of $174 billion in revenue. Renting building space—such as an apartment, office, or storefront—is one of the most common examples of leasing, or the process of exchanging money to access an asset for a predetermined period. Similarly, a lease is a contractual document outlining an agreement’s terms. Companies also lease equipment, vehicles, machinery, and technology.

If your business rents its assets or leases from others, you need to track the financial impact those activities have on your business's financial health. This is called lease accounting and, in addition to being legally required, can help you run an organized, successful business.

What Is Lease Accounting?

Lease accounting is the process by which a company records the financial impacts of its leasing activities. Leases that meet specific classification requirements must be recorded on a company’s financial statements. Here’s a brief review of each financial statement:

• Balance sheets track a company’s assets, liabilities, and shareholder equity and must always balance.
• Cash flow statements show the movement of money into and out of a company during a specific period.
• Income statements track a company’s income and expenses over time.

The way a lease is recorded on each financial statement differs based on whether you’re the lessor (you own the asset and are receiving payment from the lessee) or the lessee (you’re paying to use the lessor’s asset). When recorded correctly, these three documents provide a clear picture of the value of a company’s assets and the impact the lease has on its overall financial health.

There are two lease classifications—operating and financing—that determine how your company should account for its leases in financial statements, depending on the length of the lease term.

Related: Financial Statement Analysis: The Basics for Non-Accountants

Operating Leases vs. Financing Leases

Operating Leases

Operating leases are leases that don't present an opportunity for the lessee to gain ownership of an asset.

Under the new accounting standards, operating leases must be reported on a company’s balance sheet only if the lease term is greater than 12 months. If the lease term is equal to or less than 12 months, the Financial Accounting Standards Board (FASB) doesn't require their inclusion on the balance sheet.

For an operating lease with a term equal to or less than 12 months:

• The lessor reports the individual lease payments as income on the income and cash flow statements.
• The lessee reports the individual lease payments as operating expenses on the income and cash flow statements.

For an operating lease with a term of more than 12 months:

• The lessor reports the lease as an asset on the balance sheet and individual lease payments as income on the income and cash flow statements. They must also account for the asset’s depreciation over time.
• The lessee reports the lease as both an asset and a liability on the balance sheet and reports individual lease payments as expenses on the income and cash flow statements.

Financing Leases

Financing leases, formerly called capital leases, are leases in which the lessee has reasonable expectation to gain ownership of an asset. Under the United States Generally Accepted Accounting Principles (US GAAP), there are five criteria, only one of which needs to be met for a lease to be considered a financing lease:

• The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
• The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
• The lease term is for the major part of the remaining economic life of the underlying asset unless the commencement date of the lease falls at or near the end of the economic life of the underlying asset.
• The present value of the sum of lease payments and any residual value guaranteed by the lessee (not already reflected in lease payments) equals or substantially exceeds all of the fair value of the underlying asset.
• The underlying asset is of such a specialized nature that it’s expected to have no alternative use to the lessor at the end of the lease term.

For financing leases, regardless of the term length:

• The lessor reports the lease as a leased asset on the balance sheet and individual lease payments as income on the income and cash flow statements.
• The lessee reports the lease as both an asset and a liability on the balance sheet due to their stake as a potential owner of the asset and their required payment. They also report individual lease payments as expenses on the income and cash flow statements.

Old vs. New Lease Accounting Standards

The original lease accounting standards, called the Statement of Financial Accounting Standards 13 (SFAS13) or US GAAP Accounting Standards Codification (ASC) 840, were issued in 1976 by the FASB.

A financing lease, which was called a capital lease at the time, had different criteria than those stated above:

• The lease transfers ownership of the leased asset to the lessee at the end of the lease term.
• The lease contains an option allowing the lessee to purchase the leased asset at a bargain price at the end of the lease term.
• The lease term is greater than or equal to 75 percent of the asset’s economic life.
• The present value of the minimum lease payments (including any required lessee guarantee of residual value of the leased asset to the lessor at the end of the lease term) is greater than or equal to 90 percent of the fair value of the leased asset at the inception of the lease.

Previously, it was standard that no operating leases were reported on the balance sheet. To avoid having to report capital leases, lessors would skirt the criteria of a capital lease (for instance, cutting it as close as possible to the 75 and 90 percent benchmarks) and make it look like an operating lease. This is because keeping those leases off the balance sheet would reduce tax liabilities.

To address this, the new lease accounting standards—called the Accounting Standards Update 2016-02 (ASU-2016-02) or US GAAP ASC 842—were issued by the FASB in February 2016 and went into effect for public companies in December 2018, and one year later for private entities.

Now, all leases with terms greater than 12 months—regardless of classification—must appear on the balance sheet.

Why Is Lease Accounting Important?

Accounting is crucial to understanding a company's financial health; with so many facets of accounting to consider, each plays a key role in providing financial insights that can influence organizational strategy and guide decision-making.

“Accounting is a tool that opens doors to key information, provides useful insights, helps gain perspective, and aids in decision-making,” says Harvard Business School Professor V.G. Narayanan in Financial Accounting, one of the three courses that comprise the Credential of Readiness (CORe) program.

Lease accounting was recently added to the course content of Financial Accounting. Professor Narayanan explains lease accounting’s importance and the full course update in the video below:

View Video

It’s important to understand the ins and outs of lease classification and stay up to date on the current lease accounting standards. You also need to know how lease accounting fits into each financial statement so you can base decisions and strategies on accurate financial information.

Whether your company is the lessor or the lessee, the way you keep track of assets, liabilities, income, and expenses generated by leasing activities will have an impact on the overall picture of your company’s financials and, as such, its strategy.

Are you interested in sharpening your financial accounting skills? Explore our eight-week online Financial Accounting course or three-course Credential of Readiness (CORe) program to learn how strong accounting skills can enable you to meaningfully contribute to your organization and advance your career.