Are you new to the world of accounting and financial management? Do you know what operating and finance leases are? Well, you are in the right place! This post will explore the differences between the two types of leases and their accounting implications.

What Are Operating and Finance Leases? 🤔

Leasing is an important part of asset financing. It allows companies to use assets without owning them, providing flexibility for short-term needs, such as property, motor vehicles, or specialized equipment. Lease agreements are usually divided into two categories: operating leases and finance leases.

Operating Lease

An operating lease is a short-term agreement in which a company leases an asset from another party. Operating leases do not result in ownership of the asset. The lessor retains ownership of the asset, and the lessee pays to rent it for a specified period of time.

Finance Lease

A finance lease is a long-term agreement in which the lessee takes ownership of the asset at the end of the lease term. This type of lease is used for items that have a long lifespan, such as buildings or machinery.

How to Account for Operating Leases 📊

In accounting, lease classification determines how a lease is recorded in an organization’s financial statements. The Financial Accounting Standards Board’s (FASB) Accounting Standards Update (ASU) 2016-02 changed the way operating leases are accounted for. These changes came into effect for U.S. companies that have fiscal years beginning on or after December 15, 2018, and for Canadian companies that have fiscal years beginning on or after January 1, 2019.

Under the new standard, a company must recognize an asset and a liability on its balance sheet for operating leases with lease terms greater than 12 months. The asset represents the right to use the leased asset, while the liability represents the obligation to make lease payments.

Before the new lease accounting standard, companies would only record the lease payments as an expense in the income statement. As a result of the new standard, companies must report the interest expense and depreciation of the leased asset separately.

A balance sheet with assets and liabilities

How to Account for Finance Leases 📝

Finance leases differ from operating leases in that they are treated as a purchase of a leased asset for accounting purposes. A finance lease is recorded as an asset and liability on the balance sheet at the beginning of the lease term, with the asset gradually decreasing over the lease term as the lessee makes lease payments.

At the end of the lease term, the lessee takes ownership of the leased asset. In contrast to operating leases, finance leases can result in a net gain or a net loss on the income statement as a result of the capitalization of the asset.

A balance sheet showing asset and liability changes over time

Other Implications of the New Lease Accounting Standard 🧐

One other important consideration is that the new lease accounting standard does not alter the classification of a lease as operating or finance. Rather, it changes how operating leases are accounted for on the balance sheet.

Another implication of the new lease accounting standard is that companies will need to review their lease contracts and ensure that they contain all of the necessary information required for accounting. This may include information on lease term, payment terms, and renewal options.

Finally, the new lease accounting standard may also impact loan covenants, as the inclusion of operating leases on the balance sheet may affect a company’s financial ratios.

Conclusion 🤝

In conclusion, the new lease accounting standard represents significant changes in the way operating leases are accounted for. The new standard requires the capitalization of operating leases, which has important implications for how leases are reported on an organization’s financial statements.

Lease classification is an important consideration in accounting for leases, and understanding the differences between operating and finance leases is crucial to ensuring accurate accounting practices.

A busy office with accountants working

📚 References:

American Institute of CPAs (AICPA). (2020). Understanding the new lease accounting guidance.https://www.aicpa.org/content/dam/aicpa/research//standards/leases/downloadabledocuments/Understanding%20the%20New%20Lease%20Accounting%20Guidance%20V2.pdf

Financial Accounting Standards Board (FASB). (2016). Accounting standards update no. 2016-02- leases (topic 842). http://www.fasb.org/resource/pre-codification/educational_materials/leases.html