Types of Leases
Leasing is a common practice used by businesses to acquire the use of assets without having to purchase them outright. There are different types of leases that businesses can use depending on their needs and financial situation.
Understanding the different types of leases and their accounting treatment is important for accurate financial reporting and compliance with lease accounting standards. Understanding lease classifications is fundamental to ASC 842 compliance. For comprehensive guidance on classification criteria, accounting treatment, and all other ASC 842 topics, see our complete ASC 842 guide.
The two main types of leases are operating leases and finance leases. Let's take a closer look at each one:
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Operating Lease
An operating lease is a lease agreement where the lessee does not assume ownership of the leased asset and the lease term is less than the useful life of the asset. This type of lease is often used for short-term or low-value assets such as office equipment, vehicles, or computers.
The lessor retains ownership of the asset and is responsible for maintenance and repairs.
Accounting Treatment: Under ASC 842, operating leases are treated differently than finance leases. Operating lease payments are recognized as expenses on the income statement.
Under ASC 842, the lease asset and liability are recorded on the balance sheet at the present value of the lease payments. The lease liability is amortized over the lease term.
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Finance Leases
A finance lease is a lease agreement where the lessee assumes ownership of the leased asset at the end of the lease term. The lease term is usually longer than the useful life of the asset.
This type of lease is often used for high-value assets such as machinery or buildings. The lessee is responsible for maintenance and repairs of the asset during the lease term.
Accounting Treatment: Finance leases are recorded differently than operating leases. The lease asset and liability are recorded on the balance sheet at the present value of the lease payments.
The lease liability is then amortized over the lease term, and the lease asset is depreciated over the useful life of the asset.
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Other Types
In addition to these two main types of leases, there are also other types of leases such as sale-leaseback arrangements, leveraged leases, and direct financing leases. Each type of lease has its own unique characteristics and accounting treatment.
It is important for businesses to understand these differences in order to comply with lease accounting standards and provide accurate financial reporting.
Four of these come up often enough for a lessee to be worth naming individually:
- Short-term leases. A lease of twelve months or less, with no purchase option reasonably certain of exercise, may be kept off the balance sheet by election — by class of underlying asset, not lease by lease. See short-term leases under ASC 842.
- Subleases. When you re-let an asset you hold under a head lease, you are lessee on one contract and lessor on another, and the two are accounted for separately rather than netted.
- Sale-leasebacks. You sell an asset and lease it back. Whether it is a sale at all is the first question, and if it is not, the proceeds are a financing rather than a disposal — what sellers of a sale-leaseback should know covers it.
- Embedded leases. Not a lease type anyone signs, but the category that most often goes missing: a right to control an identified asset sitting inside a service, logistics or managed IT contract. See identifying embedded leases.
Leveraged leases and direct financing leases are lessor classifications. If you are the lessee, they describe the other side of your contract rather than your own accounting.
Which Type Is It? That Is a Classification Question
Naming the types is one thing; deciding which one a given contract is comes down to five criteria in ASC 842-10-25-2 — transfer of ownership, a purchase option reasonably certain of exercise, a lease term that is a major part of the asset's remaining economic life, a present value amounting to substantially all of its fair value, and an asset so specialized it has no alternative use to the lessor. Meet any one and it is a finance lease. The tests, the benchmarks people use for them, and why ASC 842 removed ASC 840's bright lines are set out in ASC 842 lease classification.
Choosing the Right Lease Type for Your Business
Understanding the different types of leases and their accounting treatment is important for businesses to make informed decisions about leasing assets and comply with lease accounting standards.
While there are different types of leases, operating leases and finance leases are the two main types and are treated differently under ASC 842 lease accounting standards.
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At iLeasePro, we understand every aspect of leasing, including lease accounting. That means we know what lease features are involved, how calculations need to be performed and recorded, and how you can best use your leases and lease data as a business asset.
We also know the ASC 842 standard inside out, and as such we know how lease accounting software has to work to be compliant with that standard.
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