What Is Lease Accounting?

Lease accounting is the accounting process for recording the financial impacts of an organization’s leasing activities in their accounting calculations and reports.

Beginning in December of 2018 (effective December 2020 for private companies) the FASB issued new lease accounting standards, updating how companies are required to account for operating leases on their balance sheets. Previously companies capitalized their financing leases only, while simply disclosing their operating operating leases in the footnotes. Under the new rules, right-of-use assets and lease liabilities for all operating leases longer than 1-year are recorded on the balance sheet.

Comparing Operating Lease vs. Finance Lease

An “operating lease” is a right-to-use lease for an asset, without transferring ownership rights. A “finance lease” (formerly referred to as a “capital lease”) are all other types of leases. They are similar to operating leases but their terms transfer more rights so they are closer to ownership. A finance lease meets one of five qualifications: the title transfers at its end; the lessee has a purchase option that is reasonably certain to be exercised; the term of the lease is more than 75% of the useful life of the asset; the present value of the lease payments are more than 90% of the fair market value of the asset; or the leased asset is specific enough to the lessee that the lessor (owner) has no way to transfer it to another lessee. 

What Are Lease-Option Purchases?

A lease-option purchase is a contract that gives the lessee (renter) an option to purchase the asset during or at the end of the lease term. When a lease-option is in place, the owner of the asset is barred from selling it to anyone else. At the end of a lease-option contract term, the lessee must either exercise their right to purchase the asset or forfeit it.

When Real Estate Leasing Options Make Sense for Buyer and Seller

Leasing provides an opportunity for the owner of the asset to collect income on it without forfeiting ownership, and gives the tenants more flexibility with their payments than purchasing while shouldering less responsibility than ownership. This can be especially beneficial in a high-property value area, where significant down-payment requirements or difficulty in qualifying for financing can be challenges for individuals or businesses. Similarly, if the asset’s owner is no longer using it but wishes to continue collecting income on it or finds it is not a good market to sell, leasing it out can be a viable short- or long-term solution. 

Lease Accounting Topics