Lease Accounting

Lease accounting is the area of financial reporting that deals with contracts giving one party the right to use an asset owned by another for a period in return for payment. It determines whether and how a lease appears in the balance sheet, how the cost or income is spread over time, and what must be disclosed. Leasing is a major source of finance for property, aircraft, ships, vehicles and equipment, so the rules affect the reported assets, debt and profit of most large organisations.

Two standards now govern most of the world's listed companies: IFRS 16 under international standards and Topic 842 under US rules, both effective from 2019 for public companies. Each requires a lessee to recognise nearly all leases on the balance sheet. They replaced older standards under which many leases were kept off it.

Earlier rules, dating from the 1970s and 1980s, divided leases into two classes. A finance lease, called a capital lease in the United States, transferred substantially all the risks and rewards of ownership and was treated like a purchase funded by a loan. An operating lease was treated as a rental, with payments expensed as incurred and the commitment disclosed only in the notes. US rules drew the line with numerical tests, such as a lease term of at least 75 per cent of the asset's life or payments worth at least 90 per cent of its value.

Because the outcome depended on which side of the line a contract fell, leases were often structured to fall just short of it. The result was large off-balance-sheet financing, particularly in airlines and retailing. Regulators and investors criticised this for decades, and after a long joint project the international and US standard-setters issued new standards in 2016.

Under both standards, a lessee recognises at the start of a lease a liability for the present value of future lease payments and a right-of-use asset of broadly the same amount, adjusted for initial costs, prepayments and incentives. Short-term leases of twelve months or less may be left off the balance sheet, and IFRS 16 has a further exemption for low-value assets.

The two standards then diverge. IFRS 16 has a single model: the asset is depreciated, usually on a straight-line basis, and interest is charged on the liability, so the total expense is higher in the early years of a lease and lower later. US rules keep two classes. Finance leases are accounted for as under IFRS 16. Operating leases are also on the balance sheet, but the income statement shows a single lease cost recognised evenly over the term.

For the lessor, both standards largely preserved the earlier approach. Where a lease transfers substantially all the risks and rewards of the asset, the lessor removes the asset from its books and records a receivable, recognising finance income over the term; a manufacturer or dealer lessor also recognises a selling profit at the start. Otherwise the lessor keeps the asset, depreciates it and recognises rental income, normally on a straight-line basis. Lessee and lessor accounting are therefore not symmetrical: the same asset can appear in some form on both parties' balance sheets.

Applying the rules is a continuing process involving finance, property, procurement and treasury teams.

• Identifying leases. Contracts are reviewed to find leases, including those embedded in service, logistics or outsourcing agreements.
• Capturing data. Key terms are extracted from each lease agreement: commencement date, payments, rent reviews, options to extend or terminate, and incentives.
• Making judgements. The lease term must reflect options the lessee is reasonably certain to exercise, and a discount rate, usually an incremental borrowing rate, is set for each lease or portfolio.
• Calculating and posting. Lease software produces the liability and asset schedules, the monthly interest and depreciation, and the journal entries.
• Remeasuring. Changes in an index-linked rent, in the assessment of an option, or in the contract itself require the liability to be recalculated.
• Disclosing. Notes show maturity analyses, expenses by type and cash outflows.

Completeness is the main control risk, since leases may be signed locally without the knowledge of central finance. Organisations with thousands of leases rely on a central lease register reconciled to payments.

Bringing leases onto the balance sheet raised reported assets and liabilities, sometimes substantially, and changed common ratios. Leverage increased. Under IFRS 16, profit before interest, tax, depreciation and amortisation rose because rent was replaced by depreciation and interest, while under US rules operating lease cost still reduces that measure, which complicates comparison between companies using different frameworks. Many groups amended financial covenants so that they continued to be tested on the old basis. Rating agencies and analysts, who had long estimated lease debt from the notes, now use reported figures, with adjustments for the differences between the two standards.

• IFRS Foundation
• Financial Accounting Standards Board