The concept of leases is considered a vital source of financing for a number of entities around the globe. For the process of leasing to streamline,implementation of the leases standard is a significant effort. It affects multiple functional areas of an organization, including accounting, tax, financial reporting, financial planning and analysis, investor relations, treasury. To say, the current accounting model for leases, does not require lessees to recognize assets and liabilities arising from operating leases. Due to this concerns have been raised by financial statement users about the current lease accounting model. The current model does not reflect the true economic substance of an operating lease transaction. The reason being, a large financing resource is appeared to be missing from the balance sheet. To keep matters in place, a new lease accounting model has been made for better management of finances.
Types of LeasesA lease is an agreement or a part of an agreement that enables a person or an entity to have the right to control the use of an identified equipment, property or plant for a considerable period of time in exchange for consideration. Leases are particularly divided into two, which include:
Financial Lease:Financial leasing is an agreement that involves payment over a longer amount of time. It is a type of lease that is long-term in nature. As a result, the lessee pays a lot more than the cost of the actual property or equipment to the lessor. This cost is in the form of lease charges. It is an unalterable procedure. This type of leasing compels the lessee to bear all costs while the lessor does not render any service. This type of lease recognizes the interest expense on the lease liability and amortization of the right-of-use asset.
Operating Lease:In this type of lease, the lessee uses the asset for a definite period. The lessor bears the risk of obsolescence and incidental risks. In order to terminate the lease, there is an option for either party to terminate the lease. In this type of leasing, the following scenarios may come up:
- lessor bears all expenses
- lessor will not be able to realize the full cost of the asset
- specialized services are provided by the lessor
Outline of the Updated Lease Accounting ModelThe new lease accounting model codified as Topic 842 functions on the core principle that a lessee should recognize the assets and liabilities that arise from lease arrangements. Which means, a lessee should recognize on the balance sheet a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. Under the new standard, there continues to be a differentiation between finance leases. The lease standard requires several steps including the following:
- identifying relevant legal contracts
- evaluating whether an arrangement is or contains a lease
- applying the new leases standard to arrangements within its scope
Steps to Implement the New Accounting ModelConsidering the number of leases that companies have, adopting Topic 842 requires extra efforts. As companies are also implementing many major accounting standards, the resources that exists are getting strained. To avoid the situation to worsen further, there is a procedure to implement the new accounting model for companies to track their finance in order. The list of step include:
- Preparing an inventory of leases
- Reviewing the reporting systems used for leases
- Evaluating the disclosure requirements
- Involving various departments of the firm
Key Takeaways from "An Overview of the New Accounting Model for Leases"
- The new accounting model does represent a significant change for lessees
- Companies should take up the new model of accounting for the processes to streamline
- Topic 842 requires an extensive amount of qualitative and quantitative disclosures