Each Tuesday, ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories. First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation.
Second, we will go beyond the theory and actually cover practical aspects of fundamental accounting concepts, including the posting of debits and credit, in some cases 'manual methods' (like an old set of books) or in many cases using modern accounting software to properly recording these types of transactions. If fact we may even post transactions using our sponsor's Zoho Books.software.
Today’s article is the first in a mini-series which sets out to demystify leases, a business transaction that is many times improperly posted and accounted for, especially since many small accounting software packages do not offer 'special tracking' for leases. We will also review upcoming changes in lease reporting as recently announced by the Financial Accounting Standards Board.
Mystique of Leases - Part 1 Title
Leases. Just the utterance of the word evokes yawns. But, I’d be willing to bet that almost every reader responsible for the books and records of their business or clients’ businesses has to deal with a lease at some point. Others, like me, deal with multitudes of leases each and every year. So, while I understand the lack of sex appeal, the omnipresence of leases makes the subject worthy of discussion. In this article and its sequel, we’ll look at the two lease types, operating and capital, discuss the definitions, identify the attributes of each, review the financial presentations, and discuss the sweeping changes coming in the very near future.
As discussed in previous articles, many of the accounting principles we debate are firmly rooted in generally accepted accounting principles (“GAAP”). And, most of you, myself included, rarely prepare and publish a full GAAP financial statement. “So, why do I need to know about the proper accounting and presentation of leases when it pertains only to GAAP-based financials,” you ask? My answer is what it will always be – because the principles controlling much of the accounting we perform daily crosses over from GAAP to our cash- and/or tax-basis financial statements. Your client’s expectation that you know how to properly interpret and present either type of lease in a financial statement is inherent. That is, when you publish a financial statement, whether it is upstream to management or directly to your clients, it is tacitly understood you interpreted the accounting issues correctly and properly presented them within the financial statements.
The presentation of this subject will be divided into two parts given the breadth of the subject, and to give the reader a break (you’ll thank me later). Part One will cover the basics of a lease including the parties to a lease, the types of leases, and the attributes of each type. Part Two will cover the accounting and tax aspects of leases as well as the sweeping changes recently announced by the Financial Accounting Standards Board this year (FASB ASU 2016-2, Leases).
Definition and the Parties
Most reading this article already know the definition of a lease, but for the unindoctrinated, a bit of context would probably be appreciated. Generally, a lease is an agreement in which the owner of a particular piece of property conveys the right to use that piece of property to a third party. The lease agreement will commonly identify the parties to the lease, the equipment being leased, the duration of the lease, the periodic lease payment, and the legal terms of the lease.
There are common terms used in a lease agreement, but as is always the case in unfamiliar territory, understanding the jargon is paramount to getting it. In every lease document, you’ll see the terms lessor and lessee. The party receiving the right to use the equipment is called the ‘lessee’ while the party owning and leasing out the equipment is called the ‘lessor.’ Simply enough, right? Yeah, but many confuse the two and it is vital to get it right. My cheat sheet for remembering the parties to a lease is analogous to the employer/employee relationship. The employer is the owner of the business, while the employee is the one working in the business. Similarly then, the lessor is the owner of the equipment, while the lessee is the one using/working with the equipment. Simple, but effective.
Types of Leases
As noted at the opening of this piece, the two primary types of leases we deal with are called “operating leases” and “capital leases.” Most likely, whether you know it or not, you’ve probably been exposed to both types of leases at one point or another, but might not have known how or why they were classified as such. You may run across a lease that does not specifically refer to the lease as operating or capital, but rest assured; regardless the name, it can be classified as operating or capital just by reading the terms of the agreement.
Below is a chart comparing and contrasting various attributes of operating and capital leases. This chart provides an at-a-glance view; the detail associated with each lease type will be provided further into the piece.
Lease Comparison Chart
The most common type of lease in the market today is the operating lease. Think of an operating lease like an office rental agreement – that is, you have the right to the use of property in return for a periodic payment, but must return it to the owner (lessor) at the end of the lease. Almost every office lease is considered an operating lease. How about a copier lease? You lease a copier for 3 – 5 years, turn it back to the leasing company (lessor) at the end of the term, and get a new copier starting the process all over again (this is the classic definition of an operating lease). Generally, lessees prefer operating leases because the cash out (the lease payments) matches the corresponding expense on the income statement. In other words, every dollar spent on an operating lease is reflected on the income statement as an expense. This makes the accounting very easy.
A capital lease is a lease that transfers the benefits and risks of ownership from the lessor to the lessee. There are four primary attributes (or tests) qualifying a lease as a capital lease, but only one of those attributes must be met to classify the lease as capital.
The four attributes (tests) of a lease to determine if it qualifies for capital lease treatment are:
- Ownership - if the lease transfers the ownership of the property to the lessee at the end of the lease term, the lease is considered capital.
- Bargain Purchase Option – if the lease contains an option allowing the lessee to purchase the property at a price less than current fair market value (thus, a bargain purchase), the lease is considered capital.
- Estimated Economic Life – if the lease term equals or exceeds 75% of the estimated economic life of the property, the lease is considered capital. For instance, if the estimated economic life of a computer is estimated at five years, and the lease term is four years, the lease would be considered capital (four years divided by five years = 80%).
- Fair Value – if the present value of the lease payments equals or exceeds 90% of the fair market value at the inception of the lease, the lease is considered capital.
If none of these tests are met, the lease should be classified as an operating lease. This, by itself, creates a mandate to those responsible for a company’s books and records to read each lease agreement to assess it for the four capital lease attributes and the properly classify the lease as operating or capital. Yep, you heard it…read the lease agreement!
The Bottom Line
As stated at the beginning of this article, generally accepted accounting principles require the proper identification, presentation, and disclosure of leases as either operating or capital. However, if your company or your client’s company is a party to a capital lease and you present your financial statements under the income tax basis of accounting, don’t you think you’d better know how to record the proper assets and liabilities on your balance sheet? The correct answer to the question is yes. If you don’t, you just misstated your client’s balance sheet.
In the next edition, we’ll discuss the accounting and tax presentations for each lease type and take a look at the massive changes coming.