Many businesses lease certain assets rather than buy them outright. The accounting rules for long-term leases have undergone significant changes with the introduction of updated guidance aimed at increasing transparency and comparability in financial reporting. This article provides an overview of the current accounting rules for reporting leases.
Updated rules
Under current U.S. Generally Accepted Accounting Principles (GAAP), companies must report finance and operating leases on their balance sheets. However, there’s an exception for short-term leases with terms of 12 months or less.
Finance (or capital) leases transfer substantially all the risks and rewards of ownership to the lessee. These arrangements are reported as a right-of-use asset and a corresponding lease liability on the balance sheet. Reporting for finance leases hasn’t changed under the updated guidance.
Operating leases don’t transfer substantially all the risks and rewards of ownership. They’re commonly used for buildings, equipment, vehicles and technology assets. Operating leases weren’t recorded on the balance sheet before updated guidance went into effect in 2019 for public companies and 2022 for private entities.
Under the updated guidance, lessees must recognize a right-of-use asset and a lease liability for operating leases, but the expense recognition pattern differs from finance leases. Generally, the asset and liability are based on the present value of minimum payments expected to be made under the lease, with certain adjustments. Present value is calculated using the interest rate implicit in the lease or the lessee’s incremental borrowing rate if the implicit rate isn’t readily determinable. Lease expense is recognized on a straight-line basis over the agreement term. Changes (such as extensions, terminations or modifications to lease payments) may require remeasurement of the lease liability and corresponding adjustments to the right-of-use asset.
Reporting hurdles
Implementing the updated guidance has been a struggle for private companies with significant operating leases. Embedded lease arrangements may be particularly challenging. These nontraditional arrangements are sometimes found in service, supply, transportation, contract manufacturing or information technology agreements. For example, suppose a transportation contract gives your company exclusive rights to, and control over, a specific vehicle or fleet of vehicles. In that case, it should be treated as an embedded lease and the contract’s lease and nonlease components must be separated for financial reporting purposes.
Private companies may be tempted to issue non-GAAP financial statements to avoid the hassle of locating all their leases and extracting the data necessary to comply with the updated accounting standard. While non-GAAP reporting may simplify matters, stakeholders typically prefer GAAP financials over those prepared under another basis of reporting. Exceptions to GAAP can be problematic if you want to merge, sell your business, find equity investors, refinance existing debt or apply for new loans.
Get it right
Your CPA can help you understand today’s lease accounting rules and gather the data that’s required under the updated guidance. Many lease-intensive companies use accounting software to automate managing and tracking their leases and calculating their lease-related assets and liabilities. Contact your accountant for more information.
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