Lease Accounting Rules

Understanding the rules can be tedious. That's why we're here to help. 
Proper FAS 13 accounting can be tremendously complex. In fact, FAS 13 was the most complex accounting standard issued up to its time. Financial Computer Systems takes the mystery out of lessee lease accounting.
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The regulations in the United States that specify how leases should be accounted for are issued by the Financial Accounting Standards Board (FASB), a Norwalk, CT, based private organization that is officially recognized by the United States government and the accounting profession as the rule-making body for accounting. Any company with publicly-traded stock or bonds must comply in full with GAAP (generally accepted accounting principles), which means complying with the FASB's regulations. FASB rules are known by their number. For instance, the main statement on leases was number 13, issued in 1976. It is generally known as FAS 13 (also called SFAS 13 or FASB 13). It has been amended several times, for instance by FAS 22, FAS 23, FAS 27, FAS 28, FAS 29, FAS 98, and FAS 121. In addition, numerous interpretations and technical bulletins have been issued giving additional guidance. Previously labeled as section L10 in the FASB Current Text, the new FASB Codification uses section ASC 840 for all of the lease accounting rules and guidelines. The discussion below primarily focuses on lessee accounting (i.e., the accounting for those who use the asset and pay the rent), since FCS works primarily with lessees.
United States governmental accounting for leases is almost the same as for corporations, although the Governmental Accounting Standards Board's GAS 13 (the number is only coincidentally the same as FAS 13) prescribes different handling of some operating leases with scheduled rent increases. A new GASB standard for lease accounting is in final stages of development, with implementation expected in 2020. Currently, the standards of the International Accounting Standards Board (IASB) vary somewhat; follow this link for a list of differences between FAS 13 and IAS 17.
This page discusses FAS 13. See Summary of ASC 842 & IFRS 16 for a description of the new lease accounting standards promulgated in 2016, which take effect in 2019.


The Basic Concept of Lease Accounting: 
Some leases are merely rentals, whereas others are effectively purchases. For instance, if you rent office space for a year, the space is worth nearly as much at the end of the year as when you started; you are simply using it for a short period of time. This rental is called an operating lease. If you lease a computer for five years, however, at the end of the lease the computer is nearly worthless. The lessor (the person who receives the rents) anticipates this, and charges the lessee (the person who uses the asset) a rent that will recover all of the lease's costs, with a profit built in. This is essentially a purchase with a loan, which is called a capital lease, and an asset and liability must be set up on the lessee's primary financial statements. Rental payments are considered repayments of the loan; depreciation and interest expense, rather than rent expense, are shown on the income statement. For further explanation of terms used in lease accounting, see the glossary.
Operating leases do not normally affect a company's balance sheet. There is, however, one exception. If a lease has scheduled changes in the rent (for instance, a planned increase for inflation, or a rent holiday for the first six months), the rent expense is to be recognized on an equal basis over the life of the lease. The difference between the rent expense recognized and the rent actually paid is considered a deferred liability (for the lessee, if the rents are increasing) or asset (if decreasing). You can look at an example of the accounting for an operating lease.
Whether capital or operating, the future minimum rent commitments must also be disclosed as a footnote to the primary financials. This commitment is broken out by year for the first five years, then all remaining rents are combined.
 A lease is capital if any one of the following four tests is met:

 1) The lease conveys ownership to the lessee at the end of the lease term;
 2) The lessee has an option to purchase the asset at a bargain price at the end of the lease term
 3) The term of the lease is 75% or more of the economic life of the asset.
 4) The present value of the rents, using the lessee's incremental borrowing rate, is 90% or more of the fair market value of the asset.
Note: Each of these criteria, and their components, is described in more detail in FAS 13 (codified as ASC Topic 840).


Once a Lease is Set Up:

After a lease is set up as a capital lease, the asset is depreciated, over the asset's economic life if there is an ownership transfer or bargain purchase option; otherwise, over the term of the lease. The liability is amortized using the "interest method:" Interest is accrued on the remaining liability, and paid off with each rental payment; the excess payment goes to liability reduction, with a constant interest rate maintained throughout the life of the lease. This is the same method of repayment as is used for a standard home mortgage. You can look at an example of the accounting for a capital lease.