NetSuite is a well-known accounting software solution. Organizations enjoy using NetSuite because of the wide range of accounting functionalities and customer support it offers. Recent changes to the lease accounting standards have impacted how CPAs and other financial professionals use NetSuite lease accounting software.
How Lease Accounting Works
This type of accounting is the financial management of leases. A lease is a type of contract that allows a person or business to give someone else the right to use their equipment, services, or property. In exchange, the lessee will pay a pre-agreed payment amount. Two common lease types are finance leases and operating leases.
Leasing is beneficial to companies as it gives them a way to have cash flow. It is different from an outright purchase. With an outright purchase, there is an upfront infusion of cash. With a lease, a set amount of cash is paid to the lessor at predetermined intervals.
From the lessee’s standpoint, leasing is beneficial because they enjoy:
- Flexible payment schedules
- Not having leased equipment as a liability on the company’s balance sheet
- The ability to improve equipment, tools, and vehicles by upgrading the items once the initial lease is complete.
- Reduced obsolete tools and equipment because it easier to replace leased items
Think, for example, of a company that has several vehicles for their employees. If they purchase vehicles brand-new, they would be solely responsible for the upkeep and maintenance of the vehicles and would have the responsibility to sell the vehicles once they reach the end of their service life.
However, with the leasing arrangement, the company always has reliable new cars that are maintained by the dealership for a stipulated monthly payment. The dealership benefits because they can sell like-new vehicles for a profit on top of the money they have made from the lease.
As with all business deals, there are also disadvantages for both sides. The lessor has limited control over how and when payments are made. Nor can they control how the items they are leasing are treated. Accountants refer to this lack of control on the part of the lessor as the agency costs of leasing.
Generally Accepted Accounting Principles (GAAP) require companies to identify their leases. These leases must be evaluated to ensure that they meet model guidelines and that each lease is properly accounted for. NetSuite lease accounting software includes tools designed to simplify this form of accounting.
What Is the Difference between a Financing Lease and an Operating Lease?
Operating leases, also referred to as capital leases, and financing leases are the two most popular types of leases. To distinguish between the two, you need to understand how much risk and how much reward for owning the assets a lessor has given to the lessee.
If there was a full transfer of risks and rewards, this is a financing lease based on IFRS standards. If there is not a complete transfer of risks and rewards, then it is an operating lease. Common examples of operating leases are the leases between an apartment renter and their landlord.
How do both parties know if the risks and rewards have been completely transferred to the individual who is leasing the property or machinery? To clarify any doubts, the IFRS has laid out characteristics that separate the two types of leases.
In order to be a financial lease, the following must be true:
- The lease lasts for most of the useful economic life of the asset, which is typically 75 percent or more.
- A bargain purchase option must exist. This means that the lessee has the option to purchase the item they are leasing at a future date for a reduced price. For example, a person might lease a car for 12 months and then at the end of the 12 months have the option to purchase the vehicle for less than the fair market value. The terms and conditions for this purchase are typically established when the lease is first created.
- Finally, the net present value of minimum lease payments should be at least 90 percent of the asset’s fair value.
Fact To Remember
In 2016, the FASB (Financial Accounting Standards Board) added criteria. If an asset is so specialized that the lessor has no alternative use for the item once the term of the lease is complete, it is viewed as a finance/capital lease.
Companies that have finance leases record the asset and any liability connected to it on their balance sheet. They can deduct computed compound interest from the lease payments every year on their income statement.
Accounting for a lease has four steps
All four steps can be recorded in NetSuite lease accounting software. These include:
- Recording the current value of all lease payments. This is the cost of the lease.
- Recording just the interest portion of payments as an expense.
- Depreciating the recognized cost for the asset through its lifecycle.
- Once the asset is retired, its disposal must be recognized.
Lessor Accounting for Capital Leases
US GAAP requires that the lessor keep track of the capital lease as a direct finance lease if the carrying value and the lease payments are the same amounts. When the current value of the lease payment is higher than the asset carrying value, the lease will be recorded as a sales-type lease.
In NetSuite lease accounting, the lessor will report both direct finance leases and sales-type leases on their financial statement as:
- Balance Sheet: The lease receivable is reported using the present value of the lease payments
- Income Statement: The interest revenue is recorded based on lease receivables calculated using the interest rate from the beginning of the loan.
- Cash Flow Statement: The interest components will be recorded as operating cash flow and the principal will be recorded as investing cash flow.
Here’s a practical example of a finance/capital lease.
Taaltek Communications agrees to lease data servers from XYZ Server Supply. The value of the lease is $3.5 million over the course of six years. The servers have a useful life of seven years.
According to the contract, Taaltek Communications pays the lease monthly over the course of six years with an implicit annual interest of 10 percent. At the end of the lease, there is no salvage value. However, Taaltek Communications has the option to purchase the servers at a price that is less than their fair market value.
This meets all the criteria for a capital lease. The servers do not transfer ownership, there is the option for the lessee to purchase the servers for less than market value, the servers are used for 86 percent of their useful life, and the present value of the lease rental is above the 90 percent requirement.
Using NetSuite lease accounting, the accountants will now split the total lease into principal and interest. Then, the depreciation of the servers will be split between the 72 payments made over six years. With a capital lease accounting agreement, Taaltek Communications will pay to clear the finance lease principal and interest during the six-year loan.
Removing the Complexity of Accounting
Fusion CPA is a team of experienced accountants, bookkeepers, and financial advisors. We can help you keep accurate books whether you are the one leasing your equipment out or the one leasing equipment. NetSuite is just one of many accounting tools that we have at our disposal. We look forward to showing you how you can make the most of your money. Press the button below for more information.
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