Most companies, whether they are brand new or have been around for a while can benefit from leasing options. Leasing is a great option for companies who battle to cover the cash layout for new equipment or to add to their fleet.
This is totally normal, whether they are a startup or not, and in a lot of cases, finance advisors would lean more toward leasing options over buying. Even with financial capabilities, companies usually steer clear of using the working capital of the organization for buying new equipment, and rather promote equipment financing.
With this in mind, we thought that we would look into lease accounting as a financing option. We took a look into what lease accounting is and its basic components. We decided to outline the distinctions between the two most prevalent lease agreements. So, let’s get stuck in.
What Is Lease Accounting?
Essentially, lease accounting is the process by which a business tracks and accounts for different leases. It will need to record the financial implications of the lease and record each transaction that is part of the lease process.
Leases are usually taken out by a company when they need new equipment or to add to their fleet and cannot use the working capital for these purposes. Working capital is utilized for day-to-day expenses and compensation, as opposed to such a large purchase. Leases need to be recorded on a company’s financial statements correctly, with each lease having different requirements and specifications.
It will appear on each financial statement in the following ways:
- The balance sheet allows a company to track assets, liabilities, and shareholder equity. The balance sheet will always need to balance;
- A cash flow statement will display how money is moved in and out of a company over a period of time;
- The income statements indicate what income is coming into the company and what money is being spent on.
Together these three documents provide a clear picture of what is coming into the company and what is going out. It also indicates your company’s financial health. Lessors will record the lease differently from the lessee.
What is important to know is that there are two different types of leases. Lessees can opt for either an operating lease or a financing lease.
What Are The Main Differences Between Operating Leases And Financing Leases?
Let’s unpack what the basic differences between the leases are and what impacts they will have on the financial statements.
Operating leases are leases where the lessee will never gain ownership of the equipment or vehicle that they are leasing. They will usually return it after the agreed upon period.
These are leases that are usually centered around equipment for the company. Under the new IFRS accounting standards, these only need to be reported on the balance sheet if the lease term is more than a year.
For operating leases under or equal to a year you will need to report it as follows:
- The individual lease payments are recorded as income by the lessor on the income and cash flow statements.
- The individual lease payments are listed by the lessee as operating expenses on the income and cash flow statements.
For more than 12 months:
- The lessor includes the lease as an asset on the balance sheet and as income on the income and cash flow statements for each individual lease payment. The asset’s deterioration over time must also be taken into consideration.
- Lessee reports lease as asset and liability on the balance sheet and lease payments as expenditures on income and cash flow statements.
Financing leases, on the other hand, provide the lessee with the opportunity to eventually buy the equipment. Ownership will be transferred to the lessee at the end of the term. 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.
They are reported as follows:
- The lessor puts the lease on the balance sheet as a leased asset and each lease payment as income on the income and cash flow statements.
- The lessee accounts for the lease as both an asset and a liability on the balance sheet.
- Individual leasing payments are also recorded on the income and cash flow statements as expenses.
The Bottom Line
When undertaking a lease, it is highly advisable to hire a knowledgeable financial advisor. The reporting of the leases is critical and meeting the relevant accounting standards is key for your company. If you are leasing a large piece of equipment at a substantial price, we also recommend hiring an experienced attorney.