Implementing new lease accounting standards can be confusing for lessors.
This article will clearly explain key concepts, differences, and examples of lessor accounting under IFRS 16 and ASC 842.
You'll learn about operating versus finance leases, measurement and disclosure requirements, journal entries, data challenges, and steps for compliance.
Introduction to Lessor Accounting Practices
The introduction of new lease accounting standards IFRS 16 and ASC 842 has led to significant changes in how lessors must account for leases. This section provides an overview of key concepts and trends to help lessors navigate the new standards.
Understanding the Landscape of Lessor Accounting Under IFRS 16 and ASC 842
The new standards require changes to lease classification, measurement, presentation, and disclosure. Key impacts include:
- Operating leases are accounted for similarly to current lease accounting, while finance leases recognize interest income and lease receivables.
- More judgment is required in classifying leases as operating or finance.
- Enhanced disclosure requirements provide more transparency into lease assets and liabilities.
By understanding these landscape changes, lessors can effectively adapt their accounting practices.
Essential Concepts in Lessor Accounting: Operating and Finance Leases
Under the new standards, lessors must classify leases as either operating or finance based on criteria like lease term and underlying asset value.
Operating leases function similar to rentals. The lessor retains ownership of the asset and recognizes lease income over the lease term.
Finance leases transfer substantially all risks and rewards of ownership to the lessee. The lessor derecognizes the asset and recognizes a lease receivable and interest income.
Proper classification is essential for lessors to apply the correct accounting treatment.
Navigating Lessor Accounting Challenges in the New Regulatory Environment
Implementing the new lease accounting standards presents several key challenges for lessors including:
- Determining appropriate lease classification
- Developing new processes and controls
- Enhancing disclosures and financial reporting
- Managing system and data requirements
By understanding these pain points, lessors can take proactive steps to ensure accounting compliance and minimize disruption. With careful planning and adaptation, the regulatory changes can be managed smoothly.
Does ASC 842 change lessor accounting?
The primary objective of ASC 842 was to improve accounting for leases by lessees. Accordingly, the accounting for leases by lessors remains broadly consistent with previous GAAP and varies depending on lease classification.
Key Points
- ASC 842 does not significantly change lessor accounting practices compared to previous standards. The core principles remain largely the same.
- Lessors will continue to classify leases as operating leases or finance leases. The classification determines how the lease is accounted for.
- For operating leases, lessors recognize lease payments as rental income over the lease term generally on a straight-line basis.
- For finance leases, lessors recognize interest income and a reduction of the net investment in the lease over the lease term.
Operating Leases
Under ASC 842, lessors will continue to account for operating leases similar to current guidance by recognizing lease payments as rental income on a straight-line basis over the lease term. Key aspects include:
- Lessors recognize lease payments as rental income generally on a straight-line basis over the lease term.
- Initial direct costs are deferred and recognized as expense over the lease term on the same basis as rental income.
- The underlying asset remains on the lessor's balance sheet and is depreciated.
Essentially, the lessor accounts for the lease as a continuous source of rental income over the lease term.
Finance Leases
For finance leases, the lessor recognizes interest income and a reduction of the net investment in the lease over the lease term. Key aspects include:
- Lessors recognize interest income over the lease term based on the interest rate implicit in the lease.
- The net investment in the lease is reduced over the lease term as lease payments are collected from the lessee.
- The underlying asset is derecognized from the lessor's balance sheet at lease commencement since the risks and rewards have been transferred to the lessee.
In summary, ASC 842 does not make major changes to lessor accounting practices. Lessors will continue classifying leases and recognizing income based on the lease classification. The core principles remain consistent with previous standards.
Which is the correct treatment for finance lease in the accounts of a lessor?
Accounting by lessors at commencement of the lease term, the lessor should record a finance lease in the balance sheet as a receivable, at an amount equal to the net investment in the lease [IAS 17.36].
Specifically, the lessor should:
- Recognize assets held under a finance lease in its balance sheet and present them as a receivable at an amount equal to the net investment in the lease
- Recognize finance lease income based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment outstanding in respect of the finance lease
- Recognize selling profit or loss in the period, in accordance with the policy the entity has adopted for outright sales
- Recognize costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging a lease as an expense when the selling profit is recognized
For example, on January 1, 20X1, Lessor leases equipment to Lessee for 5 years at $20,000 per year, payable at the beginning of each year. The equipment, which cost Lessor $80,000, has an estimated useful life of 8 years with no residual value. The present value of the 5 lease payments at the market rate of interest of 10% is $83,686.
Lessor would make the following journal entries:
January 1, 20X1
Dr. Lease receivable $83,686
Cr. Equipment $80,000
Cr. Selling profit $3,686
To record lease at commencement.
December 31, 20X1
Dr. Cash $20,000
Dr. Interest income $8,369
Cr. Lease receivable $28,369
To record receipt of first payment plus interest income.
This records the finance lease correctly in the books of the lessor at lease commencement and during the first year of the lease term. The key is to recognize a lease receivable and selling profit upfront, then recognize interest income over the lease term.
What is the accounting rule to be record by lessee and lessor?
The lessee records the capitalizable leased asset and the corresponding lease obligation based on the lower of the present value of the minimum lease payments and the leased asset's fair value at that time. The payments made to the lessor are recorded as a reduction in the lease obligation.
Specifically, under IFRS 16 and ASC 842 lease accounting standards:
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The lessee recognizes a "right-of-use" asset and a lease liability at the lease commencement date. The lease liability is measured at the present value of the remaining lease payments, discounted using the interest rate implicit in the lease or the lessee's incremental borrowing rate.
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The right-of-use asset is measured at cost, which comprises the amount of the initial measurement of the lease liability, plus any lease payments made to the lessor at or before the commencement date, less any lease incentives received, plus any initial direct costs incurred by the lessee.
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During the lease term, the lessee recognizes interest expense on the lease liability and depreciation expense on the right-of-use asset. Lease payments made to the lessor are recorded as reductions to the lease liability.
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The lessor classifies a lease as either a finance lease or an operating lease. A finance lease transfers substantially all the risks and rewards incidental to ownership, while an operating lease does not.
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For finance leases, the lessor derecognizes the leased asset and recognizes a net investment in the lease. Finance lease income is recognized in a pattern reflecting a constant periodic rate of return on the net investment.
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For operating leases, the lessor continues to recognize the leased asset. Operating lease income is recognized on a straight-line basis over the lease term.
In summary, the lessee capitalizes leased assets and liabilities, while the lessor either derecognizes leased assets (finance leases) or continues recognizing them (operating leases). Both lessee and lessor record lease-related expenses and income over the term of the lease.
Which is the correct accounting treatment for a finance lease in the accounts of a lessor quizlet?
The correct accounting treatment for a finance lease in the accounts of a lessor is to recognize the lease as a receivable. The lessor carries the lease at the amount of its net investment in the lease.
Specifically, the key points are:
- The lessor recognizes a finance lease receivable asset equal to the net investment in the lease
- The lessor recognizes interest income over the lease term, based on a pattern reflecting a constant periodic rate of return on the net investment
- The lessor recognizes variable payments as income in the period it is earned
- The lessor recognizes selling profit or loss at the commencement date, reducing the carrying amount of the lease receivable
So in summary, the lessor accounts for the lease as a financing transaction, recognizing a lease receivable and interest income over the term of the lease. This contrasts with an operating lease, where the lessor retains ownership of the underlying asset.
The correct treatment focuses on the finance lease receivable and interest income recognition. Tracking the net investment and ensuring proper income recognition over the lease term are key aspects for lessors under IFRS 16 and ASC 842.
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Key Differences Between Operating and Finance Leases
Operating and finance leases have distinct classification criteria and accounting treatments from the lessor perspective. Understanding these key differences is critical for proper lease accounting and financial reporting.
Criteria for Lease Classification Under IFRS 16 and ASC 842
The classification criteria focuses on transferring substantially all the risks and rewards of ownership:
- Operating leases: Do not transfer substantially all risks and rewards of ownership. The lessor retains ownership of the underlying asset.
- Finance leases: Transfer substantially all risks and rewards of ownership to the lessee. In essence, the lessee financially owns the leased asset.
Specific quantitative thresholds also determine classification. For example under IFRS 16, a lease is classified as finance if the lease term covers a major part of the asset's economic life.
Impact on the Balance Sheet: Operating vs Finance Lease Treatment
Operating leases are off-balance sheet for lessors. There is no asset or liability recognition, only disclosure of future minimum lease payments.
Finance leases require the lessor to derecognize the leased asset and recognize instead a lease receivable and unearned finance income. The lease receivable is amortized over the lease term through finance income.
Income Statement Implications for Lessor Accounting
For operating leases, the lessor recognizes lease income evenly over the lease term.
For finance leases, interest income decreases over the lease term as the lease receivable is amortized. Initial periods have higher income recognition.
In summary, classification drives major differences in balance sheet and income statement treatment for lessors. Careful evaluation of lease terms and risks transferred is needed for accurate accounting.
Lessor Accounting for Operating Leases
Operating leases allow companies to lease assets from a lessor without having to purchase them outright. Under new accounting standards like ASC 842 and IFRS 16, lessors must follow specific guidelines for recognizing and measuring these types of leases.
Initial Recognition and Measurement of Operating Leases
When an operating lease commences, the lessor does not recognize the leased asset on its balance sheet. Instead, the lessor recognizes lease payments as rental income evenly over the lease term. The pattern of recognition must reflect a constant periodic rate of return on the lessor's net investment in the lease.
Initial direct costs incurred by the lessor, such as legal fees or commissions, are included in the initial measurement of the net investment in the lease. These costs are recognized as expenses over the lease term on the same basis as rental income.
Subsequent Measurement and Modification Accounting
After lease commencement, lessors account for operating leases by recognizing lease income on a straight-line basis, deducting initial direct costs, and adding unguaranteed residual asset values. The net investment in the lease is subject to regular review for impairment.
If the contract is modified, lessors account for the modification as a separate lease if it grants the lessee an additional right of use not included in the original lease. Otherwise, modifications are accounted for as reassessments or remeasurements of the existing lease.
Disclosure Requirements: Lessor Operating Lease Disclosure Example
Lessors must disclose qualitative and quantitative information about their leasing activities, including:
- Description of leasing arrangements
- Amounts recognized in statement of financial position, income statement, and cash flows
- Total future minimum lease payments to be received
For example:
Lessor Operating Lease Disclosures
The Company leases equipment to customers under operating leases. As of December 31, 20X1 the Company has $250,000 of equipment on operating leases, recognized as property and equipment on the balance sheet.
For the year ended December 31, 20X1, operating lease income was $75,000. Future minimum lease payments to be received under non-cancelable operating leases total $450,000 over the next five years.
Lessor Accounting for Finance Leases
Finance leases transfer substantially all the risks and rewards of ownership to the lessee. As such, the accounting treatment for lessors focuses on recognizing assets, liabilities, income, and expenses related to the lease.
Measuring Lease Receivables: Finance Lease Accounting
The lessor initially recognizes assets held under a finance lease as a receivable at an amount equal to the net investment in the lease. This consists of:
- Lease payments receivable from the lessee
- Any unguaranteed residual value the lessor expects to realize
The lessor recognizes interest income over the lease term, based on a pattern reflecting a constant periodic rate of return on the net investment.
Subsequently, the lessor adjusts the lease payments receivable to reflect lease payments made, impairment losses, and revised estimates.
Accounting for Residual Assets in Finance Leases
The lessor initially recognizes the estimated unguaranteed residual value as an asset, reassessed at least annually. The lessor derecognizes the portion of the residual asset relating to guaranteed amounts payable by the lessee.
If expectations around the residual value change significantly, the lessor revises income allocated over the lease term. The lessor also reviews residual assets for impairment regularly and recognizes any losses immediately.
Distinguishing Income Statement and Cash Flows in Finance Lease Transactions
Over a finance lease term, the lessor recognizes interest income to reflect a constant rate of return on the net investment. The lease receipts reduce the net investment. Hence finance lease income impacts the income statement but may differ from actual cash flows.
For example:
- Year 1: $10,000 lease payment received, $5,000 interest income recognized
- Year 2: $10,000 lease payment received, $4,000 interest income recognized
The lessor received $20,000 cash flows but recognized only $9,000 income over two years. The difference reflects repayment of the net investment. Proper accounting segregates interest income from lease receipts.
Detailed Examples of Lessor Accounting
This section will provide practical, real-world examples to illustrate how lessors apply the accounting standards in practice.
IFRS 16 Lessor Accounting Example: Finance Lease
Here is a step-by-step example of the accounting for a finance lease under IFRS 16 from the lessor's perspective:
Lease Details
- Lessor leases equipment to lessee for 3 years
- Fair value of equipment is $30,000
- Annual lease payments are $12,000 payable at the beginning of each year
- Implicit interest rate is 6% per year
Initial Recognition by Lessor
On lease commencement date, the lessor will derecognize the leased asset and recognize both a lease receivable and unearned finance income.
- Lease receivable = $32,901 (Present value of 3 annual payments of $12,000 discounted at 6%)
- Unearned finance income = $2,901 ($30,000 - $32,901)
Journal Entry
Dr Lease receivable $32,901
Unearned finance income $2,901
Cr Equipment $30,000
Subsequent Measurement
At the end of each year, the lessor will:
- Recognize interest income on the lease receivable
- Reduce the lease receivable balance as payments are made
Year 1 Journal Entry
Dr Cash $12,000
Unearned finance income $1,974 (6% interest on lease receivable)
Cr Lease receivable $12,000
Interest income $1,974
The same entry would be made in years 2 and 3, updating the numbers accordingly.
Lease Accounting Example: Operating Lease Under ASC 842
Here is an illustration of the accounting for an operating lease by a lessor under ASC 842:
Lease Details
- Lessor leases a warehouse to lessee for 5 years
- Monthly lease payment is $2,000
- Useful life of warehouse is 20 years
- Fair value is $100,000
Initial Recognition and Measurement
The lessor will continue recognizing the warehouse asset on its books, unaffected by the lease.
Journal Entry
No entry required on lease commencement date.
Subsequent Measurement
The lessor recognizes lease income on a straight-line basis over the lease term.
Monthly journal entry:
Dr Cash $2,000
Deferred rent $166 ($100,000/20 years/12 months = $416.67 monthly expense less $2,000 monthly cash rent)
Cr Rental income $2,166
This entry records the cash received as well as the deferred rent that will be expensed later.
Journal Entries for Lessor Accounting: A Double Entry Approach
Here are some typical journal entries seen from a lessor's perspective for both finance and operating leases:
Finance Lease
On lease commencement:
Dr Lease receivable
Unearned interest income
Cr Leased asset
Gain/loss on derecognition of leased asset
Over the lease term:
Dr Cash
Unearned interest income
Cr Interest income
Lease receivable
Operating Lease
On lease commencement:
No entry
Over the lease term:
Dr Cash
Deferred rent
Cr Rental income
In summary, lessors make an initial derecognition entry for finance leases and recognize assets/liabilities. For operating leases, no change is made to the underlying asset. Ongoing entries recognize interest & rental income over the lease term for finance and operating leases respectively.
Implementing New Lessor Accounting Systems and Processes
Addressing Lease Data Challenges for Accurate Reporting
Transitioning to the new lease accounting standards requires lessors to gather extensive data on all existing leases. Common challenges include:
- Incomplete lease data and contract documentation
- Decentralized lease data stored across multiple systems
- Manual lease data collection processes prone to errors
To address these issues, lessors should:
- Perform a full inventory of all lease agreements and extract key data points
- Consolidate lease data into a structured central repository
- Automate data collection workflows to minimize manual efforts
- Validate data accuracy through robust QA checks
- Enrich lease data with calculations needed for reporting (e.g. lease liability)
With improved lease data quality and completeness, lessors can accurately recognize revenues, calculate balances, and meet disclosure requirements.
System and Software Updates to Support Lessor Accounting IFRS 16 Journal Entries
Most lessors will need to implement software upgrades or new systems to comply with the updated standards, including:
- Financial/accounting systems: To support new books, accounts, journal entries, disclosures, etc. required by the standards
- Lease management software: To consolidate lease data and automate compliance processes
- Business intelligence and reporting tools: To generate financial statements, KPI reporting, and lease disclosures
Key features to enable IFRS 16 lessor accounting journal entries and reporting include:
- Custom books and accounts for IFRS 16 assets and liabilities
- New journal entry types for initial/subsequent lease measurement
- Disclosures including maturity analysis, variable payments, options, etc.
- Centralized lease data repository with version control
Leveraging purpose-built lease accounting software can help lessors minimize business disruption during the transition.
Training and Change Management for Lessor Accounting ASC 842 Compliance
Implementing the lease accounting changes affects multiple teams across an organization. Lessors should develop training programs that:
- Provide overview sessions for all finance teams on updated policies, processes, and systems
- Conduct hands-on training for accountants on applying the new standards
- Offer specialized modules by role focusing on lease data, technology, reporting, etc.
- Maintain online training resources and quick reference guides for sustainability
Ongoing change management is critical, including regular communications from leadership reinforcing the reasons behind the updates and new best practices as teams gain experience.
With proper training and buy-in across the business, lessors can sustain compliance with the standards over the long term.
Conclusion and Key Takeaways for Lessor Accounting
Recap of Lessor Accounting Changes and Implications
The new lease accounting standards IFRS 16 and ASC 842 introduce several key changes for lessors:
- Operating leases are now accounted for differently, requiring balance sheet recognition and new disclosure requirements
- Finance leases have some revised criteria around lease classification
- New guidance around sale-leaseback transactions may impact some deals
- Enhanced disclosure requirements for additional details on lease portfolios
Overall, lessors may need to adjust their systems, processes, and controls to comply with the new standards. While changes are less extensive than for lessees, there are still important updates to understand.
Essential Steps for Lessor Accounting Compliance
To achieve compliance, lessors should focus on:
- Reviewing lease contracts to determine if any may need to be reclassified from operating to finance leases
- Updating accounting policies, procedures, and controls to align with new rules
- Enhancing lease administration software and systems to capture required data points
- Providing additional disclosures on lease portfolios and risk exposure
- Ongoing monitoring of lease accounting interpretations and amendments
Getting policies and software updated early is key to smooth adoption.
Future Outlook for Lease Accounting Standards
Some potential issues to monitor after the initial adoption of IFRS 16 and ASC 842:
- Additional amendments or clarifications around certain aspects of the standards
- Emergence of new lease accounting questions and interpretations
- Regulator feedback on compliance and disclosures
- Changes to systems and processes to improve efficiency
- Developments around sustainability reporting and climate-related disclosures
The lease accounting journey is just beginning, and lessors should stay updated on the latest developments affecting financial reporting.
