Most businesses carry out some form of leasing activity, whether it’s for real estate such as retail storefronts or warehouses or for equipment such as trucks or factory machinery. Leasing gives businesses access to important assets without having to outlay huge amounts of financial capital upfront. Leasing also helps businesses manage their cash flow, but it’s important to understand how it can impact tax reporting.
Lease Accounting Explained
Lease accounting is how your business tracks and reports leases in its financial statements, including the processes of recording, classifying and reporting lease transactions.
Australian organisations work under the AASB 16 Leases standard, which means that in their lease accounting they must identify most of their assets and liabilities for most leases on their balance sheets. Before AASB 16 came into effect in 2019, Australian businesses could record lease transactions as expenses.
Even though most leases must now be recorded on the balance sheet, there are two exceptions: short-term leases (whose lease term is less than 12 months) and leases for low-value assets, such as laptops and office furniture, but not for vehicles.
Importance of Lease Accounting
A key reason for changing the standard was to promote greater transparency. Previously, some organisations weren’t recording mission-critical assets on their balance sheets, which skewed the numbers. Now investors, lenders, and other stakeholders can have a better understanding of a business's liabilities.
In addition, reporting lease liabilities this way provides business leaders with better visibility into their commitments and helps them make more informed decisions about their business.
Types of Leases
There are two main types of leases: operating leases and finance leases. (A third, less common type is the sale-leaseback, which we go into later in this article.) With an operating lease, ownership of the asset stays with the lessor, such as in the case of renting office space. With a finance lease, ownership is transferred to the lessee at the end of the term. Another distinction is that with an operating lease, some maintenance costs may be included in the monthly payments, while these costs are borne by the lessee as part of a finance lease.
Operating Lease vs. Finance Lease
Under Australia’s AASB 16 Leases standard, the distinction between operating and finance leases for lessees has largely been eliminated. For almost all leases, lessees need to recognise on a balance sheet a “right-of-use” asset and a corresponding liability, irrespective of whether they were previously classified as operating or finance leases.
For lessors, the distinction between operating leases and finance leases still applies, with assets and liabilities needing to be reported differently depending on whether they’re classified as an operating or finance lease.
Accounting for Operating Leases
If your business leases assets such as retail space, equipment, or vehicles to other businesses without transferring ownership to that company at the end, it’s classified as an operating lease. Under AASB 16, you must:
- Keep the asset on your books as a fixed asset.
- Record the payments from the lessee as income.
- Depreciate the asset according to your usual accounting policies.
Businesses that lease these assets must recognise most of these assets on their balance sheet, which also gives them a better picture of their lease obligations. You should recognise two key items:
- Right-of-use (ROU) asset: This is the lessee’s right to use an underlying leased asset, such as retail space, for the lease term.
- Lease liability: This is the lessee’s obligation to make the lease payments for the agreed upon terms.
Accounting for Finance (or Capital) Leases
Finance leases, which are sometimes also called capital lease, require the lessee to pay a fixed monthly payment over a specified period, such as when leasing a fleet of vehicles from a dealer.
When the asset is used solely for business purposes, this lease payment is 100% tax deductible. However, when the asset, such as a company car, is provided as a benefit to employees, it may be subject to a fringe benefit tax. Consult your accounting professional to understand how specific assets are impacted.
Under the international IFRS 16 and Australian AASB 16 standards, the lessor records a finance lease as a direct finance lease when the carrying value and the lease payments are the same. If the present value of the lease payments is more than the asset carrying value, then the lessor records a sales-type lease.
For lessors, finance leases mean de-recognising the leased asset and recognising the lease income. For lessees, finance leases are treated similarly to operating leases, in terms of recognising right-of-use assets and liabilities.
Sale-Leasebacks
A sale-leaseback, or SLB, is when a company sells an asset to another company—for example, a warehouse—and then leases it back from the buyer, continuing to use it while now paying rent.
This approach can be useful for businesses that need immediate financial capital, whether due to liquidity issues, to fund expansion, or to reduce debt in a high-interest environment.
Under IFRS 16 lease accounting standards, adopted widely across the APAC region, including Australia as AASB 16, businesses must recognise the sale transaction under their revenue recognition standards. The sale must entail a complete change of control of the asset from the seller-lessee to the buyer-lessor and must be recorded as follows:
- The seller-lessee must de-recognise the asset.
- The buyer-lessor recognises a net investment and any profit or loss in the lease.
- The buyer-lessor recognises any indirect initial costs as an expense or defers them if applicable.
Furthermore, AASB 2022-5 amends AASB 16 to add further requirements when measuring sale-leaseback transactions. The amendments require a seller-lessee to subsequently measure lease liabilities arising from a leaseback in a way that doesn’t recognise any amount of the gain or loss related to the right-of-use it retains.
While, as previously noted, SLBs can be useful for a business in need of liquidity and operational continuity, it does have the potential to negatively impact the balance sheet, which may be a consideration for businesses seeking outside finance. Businesses selling an asset and becoming lessees should consider how the transaction will impact their balance sheet and ensure that any use of SLBs is aligned to the business’s strategy.
Companies on the other side of that transaction, buying the asset and then leasing it back, should consider the leaseback terms and any residual value risk, while ensuring compliance with any disclosure requirements.
What Is a Journal Entry for Lease?
A journal entry for commencement of a lease, as well as for the lease in years one, two, and three, may look like what’s below:
Lease Commencement Journal Entry
| Account | Debit | Credit |
|---|---|---|
| Right-of-Use Asset | $300,000 | |
| Lease Liability | $300,000 |
Year One Journal Entry
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | $16,530 | |
| Lease Liability | $16,530 | |
| Amortization Expense | $100,000 | |
| Right-of-Use Asset | $100,000 | |
| Lease Liability | $100,000 | |
| Cash | $100,000 |
Calculate the interest expense as lease liability in year one as $300,000 from the commencement lease liability x the discount rate:
Interest Expense = $300,000 x 0.551 = $16,530.00
Calculate the amortisation expense and ROU asset in year one as $300,000 from the commencement ROU asset divided by the 3-year lease term:
Amortization Expense = $300,000 / 3 = $100,000
Year Two Journal Entry
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | $11,930 | |
| Lease Liability | $11,930 | |
| Amortization Expense | $100,000 | |
| Right-of-Use Asset | $100,000 | |
| Lease Liability | $100,000 | |
| Cash | $100,000 |
Calculate the year two interest expense and lease liability as (the initial lease liability) - (the year one payment) + (the year one accretion) x 0.0551:
Interest Expense = ($300,000 - $100,000 + $16,530) x 0.0551 = $11,930
Year Three Journal Entry
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | $6,527.15 | |
| Lease Liability | $6,527.15 | |
| Amortization Expense | $100,000 | |
| Right-of-Use Asset | $100,000 | |
| Lease Liability | $125,000 | |
| Cash | $125,000 |
Calculate the year three interest expense and lease liability as (the initial lease liability) - (the year one payment) - (the year two payment) + (the year one accretion) + (the year two accretion) x 0.0551:
Interest Expense =
($300,000 - $100,000 - $110,000 + $16,530 + $11,930) x 0.0551
= $6,527.15
Overall, on the lessee’s balance sheet for its 3-year lease, there are the following assets and liabilities.
Balance Sheets Assets and Liabilities
| Asset/Liability | Year One | Year Two | Year Three |
|---|---|---|---|
| ROU Asset | $200,000 | $100,000 | $— |
| Lease Liability | $216,530 | $118,470 | $— |
Main Accounting Standards
When it comes to leases, Australian businesses must comply with AASB 16(opens in a new tab), which is based on the global IFRS 16(opens in a new tab) standard.
The objective is to ensure that both lessors and lessees provide relevant and transparent information, which gives a basis for users of these financial statements—such as investors, financiers, or the tax office—to accurately assess the impact these leases have on a company’s financial position, financial performance, and cash flow.
Preparing for Changes in Accounting Standards
In recent years there have been several changes in lease accounting standards across the APAC region, driven by the implementation of IFRS 16 and other local amendments. The Australian Accounting Standards Board, for example, issued AASB 16 Leases in 2016, replacing AASB 117 Leases, but it didn’t take effect until January 1, 2019.
In addition to requiring lessees to identify ROU assets and lease liabilities on their balance sheets for almost all leases, these accounting changes also required companies to capitalise most operating leases on their balance sheets, instead of just reporting them in the footnotes. On the income statement, lessors must still identify leases as either operating or financing. Short-term leases (those that last less than 12 months) are exempt from this ruling, with lessees retaining the option of whether to recognise short-term or low-value leases on the balance sheet.
IAS 17 Changes to IFRS 16
The International Accounting Standards Board (IASB) implemented new lease accounting rules, under IFRS 16 (which AASB 16 is based on), in January 2016. Those rules superseded IAS 17, which was introduced in 1982 and revised across the following decades.
IFRS 16 changes included:
Changes from IAS 17 to IFRS 16
| Rule | IAS 17 (Prior) | IFRS 16 (Now) |
|---|---|---|
| Lease Accounting | Finance leases are assets. Operating leases are expenses and treated as off-balance sheet leases. | All leases are assets and treated as such on the balance sheet. |
| Lease Expenses | Single lease rent expense | The depreciation and interest reported on the income statement |
| Focus | The party who bears the risk and reward of the lease | The party who has the right to use the asset |
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ROU Asset and Lease Liability
Under IFRS 16 Leases and AASB 16, the liability for a lease is on the lessee, which is required to make payments on its lease as measured on a discounted basis. The ROU is the asset that the lessee has the right to employ.
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Lease Incentive Accounting
IFRS 16 requires a lessee to include lease incentives in the measurement of both the ROU and the lease liability. It should be noted that lease incentives may have an impact on the ROU asset but not on the lease liability if they’re paid immediately by the lessor.
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Synthetic Lease Accounting
A company uses a special purpose entity (SPE) to hold title to a property and then leases it back from the SPE. A synthetic lease allows the company to get the tax benefits of owning property while keeping the debt off its balance sheet.
Under IFRS 10 and IFRS 16, companies are required to list their SPEs on their balance sheets if they meet the criteria for consolidation. In Australia, the AASB 10 and AASB 16 standards govern these requirements. IFRS 10 requires consolidation if the company controls the SPE, while IFRS 16 mandates the recognition of lease liabilities and ROU assets for leases, impacting the balance sheet. However, synthetic leases still provide many benefits to companies, such as decreasing their tax liability. Companies with synthetic leases account for themselves as the lender and the company leasing the space.
Future Changes to Accounting Standards
Effective January 2024, amendments to the AASB 16 standard, under AASB 2022-5, were made in the treatment of variable lease payments in SLBs, and to update the treatment of gains or losses on that type of lease. Sellers must recognise the gain or loss on the “sold” portion of the asset immediately, while any gains or losses related to the ROU asset can be deferred and recognised over the term of the lease.
The AASB conducts post-implementation reviews of various standards to ensure they’re still fit-for-purpose, which may lead to further amendments. The Board also ensures alignment with IFRS, which means any future changes to IFRS 16 will likely result in changes to the Australian standard. These changes are unlikely to alter the core principles of the standard but instead address specific issues that may arise.
Comply with Australian lease accounting standards, together with NetSuite
Whether your business is leasing vehicles, equipment, or real estate, you must ensure compliance with the latest standards. NetSuite’s financial management solution can help businesses stay on top of lease transactions and much more, using AI and automation to optimise business operations and help your business grow.
Learn more about how NetSuite can help your organisation stay compliant with the new lease accounting regulations.
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Lease Accounting FAQs
How do you record leases in accounting?
For an operating lease, lessors keep the asset on their balance sheet and recognise the lease income earned. In a finance lease, lessors remove the asset from their balance sheet and record the lease receivable, recognising interest income over the course of the lease. Lessees, on the other hand, need to record the right-of-use asset, which represents their right to use the leased asset, as well as the lease liability, which represents their obligation to make future payments.
At the start of the lease, lessees will record the ROU asset and lease liability at the present value of future lease payments. Over time, they will then depreciate the ROU asset and recognise interest payments incurred on the lease liability.
What is a lease in accounting?
A lease is a contract that gives one party the right to use an asset owned by another party for a specified period, in exchange for money. An example is a retailer renting out a shop, or a manufacturer leasing equipment.
What is IFRS lease accounting?
The International Accounting Standards Boards (IASB) is an independent body that develops and approves International Financial Reporting Standards (IFRS). IFRS 16 is the standard that applies to lease accounting.
Which accounting standards are used in Australia?
The Australian Accounting Standards Board (AASB) is the Australian body in charge of setting standards for Australia. AASB 16 is the standard developed to mirror IFRS 16. There was an amendment to the standard, called AASB 2022-5, which updated some of the treatment for sale-leaseback agreements.
Who is the lessor and the lessee?
A lessor is the party that owns the asset and leases it to another party (the lessee), for example a shopping centre leasing a retail space. A lessee is the party that has the right to use the asset for the duration of the lease term.
