Leasing is a common practice for businesses of all sizes and industries, providing a flexible way to acquire and utilize assets without the significant upfront costs of purchasing them.
Recent changes in accounting standards have placed a greater emphasis on lease accounting, requiring businesses to record and report their lease agreements accurately.
Lease accounting is among the most critical business processes due to its financial impact on a business’s balance sheet.
However, many businesses struggle to navigate the complexities of lease accounting, leading to potentially costly mistakes. These mistakes can seriously affect a business’s financial standing and credit rating.
A business can enhance financial reporting accuracy and lower the risk of non-compliance, penalties, and damaged reputation by knowing and avoiding some of the most common lease accounting mistakes.
reading to find out some common lease accounting mistakes and how you can avoid them:
1. Manual Data Handling and Accounting Calculations
Many small businesses still rely on manual accounting calculations, which can be a significant source of lease accounting errors.
Using spreadsheets or paper-based systems to make calculations and keep records can make it difficult to track critical lease information and result in major inaccuracies in financial reporting and contract renewals or terminations.
Businesses with manual accounting systems often fail to comply with ASC 842 and GASB 87 lease accounting standards, leading to regulatory penalties and financial statements misrepresentations.
It not only results in increased audit costs, but a business also loses credibility in the eyes of lenders due to inaccurate financial reporting.
To avoid these mistakes, businesses should consider implementing a lease accounting software solution, such as EZLease, that automates lease data collection, validation, and reporting.
When businesses digitalize all these lease processes, they can improve accounting accuracy, streamline leasing processes, and reduce the risk of manual data entry errors. On top of that, lease accounting software can help businesses stay updated with changes in accounting standards and regulations, reducing the risk of non-compliance.
2. Failing to Identify Lease Arrangements
Another common mistake in lease accounting is failing to identify lease arrangements. When a business overlooks or fails to classify a lease agreement properly, these lease agreements fail to appear on the balance sheet.
This can have serious consequences for a business, leading to inaccurate financial reporting and non-compliance with accounting standards such as ASC 842 and GASB 87. Businesses that fail to identify lease agreements may damage their credit rating, which results in increased borrowing costs.
To avoid making such mistakes, it is important for businesses to establish clear processes for identifying and evaluating lease arrangements.
This includes thoroughly reviewing all agreements to ensure that lease arrangements are correctly identified and classified. A lease accounting software also helps streamline the entire process of lease identification and improve financial reporting accuracy.
3. Incorrectly Classifying Leases as Operating or Finance Leases
Classifying a lease as either operating or finance can significantly affect the presentation of the lease arrangement on the balance sheet and income statement.
Operating leases are considered off-balance sheet activities, while finance leases must be properly recorded as assets or liabilities on the balance sheet.
A business incorrectly classifies leases as either operating or finance leases when it fails to apply the correct criteria for lease classification or misinterprets the terms and conditions of the lease agreement.
Misclassifying a lease can significantly impact a business’s financial statements, potentially leading to inaccurate financial reporting, overstated liabilities, and non-compliance with accounting standards.
However, businesses can easily avoid this common lease accounting mistake by clearly understanding the criteria for lease classification and its accurate application in accounting.
Businesses should analyze the terms and conditions of each lease agreement carefully to determine whether its an operating or finance lease.
This becomes even easier when businesses use lease accounting software as it classifies lease contracts on the basis of specified terms and conditions and improves the accuracy of financial reporting.
4. Misunderstanding Lease Terms and Renewal Options
When a business misunderstands the lease term and renewal options, it can lead to inaccurate lease liability and right-of-use asset calculations, resulting in overstatement or understatement of lease expenses. This can impact a company’s profitability and overall financial health.
It is imperative for businesses to thoroughly review and understand the lease term and renewal options. Financial experts and accountants should carefully analyze the lease agreement and seek clarification from the lessor when necessary to ensure that the lease term and renewal options are accurately interpreted.
When businesses clearly understand lease terms and renewal options, they can improve the accuracy of lease liability calculation and its representation in financial reporting.
5. Improperly Allocating Lease Payments between Lease Components
Improperly allocating lease payments between lease components is a common mistake businesses make in lease accounting. The components of any lease may include the following:
- Lease liability
- Right-of-use asset
- Interest expense
- Amortization expense
When a business fails to allocate lease payments between these components properly, it can result in an overstatement or understatement of lease expenses, which can impact a company’s profitability, financial health, and credibility.
6. Not Keeping Up with Changes in Lease Accounting Standards and Guidance
A critical aspect of lease accounting is staying current with lease accounting standards and guidance changes. The accounting standards for lease accounting, such as ASC 842 and GASB 87, are regularly updated. Companies must keep up with these changes to ensure that they remain compliant with the regulations.
Failing to stay up-to-date with changes in lease accounting standards and guidance is a common mistake that businesses make.
They may continue to use outdated accounting practices that are no longer in line with current lease accounting standards, resulting in non-compliance issues and regulatory penalties.
This is why it’s essential for businesses to stay up-to-date with any changes in lease accounting standards.
Businesses can keep up with changes in lease accounting standards by:
- Regularly reviewing the relevant accounting literature.
- Attending training sessions to learn about new developments in lease accounting.
- Working closely with their auditors and accounting professionals to ensure they remain compliant with the latest accounting standards and guidance.
- Using up-to-date lease accounting software.
Lease accounting processes are complex and prone to human errors that can cost businesses a fortune.
By avoiding the common lease accounting mistakes mentioned above, businesses can improve accuracy in reporting, maintain strict compliance with lease accounting regulations, and maintain their credibility.
To avoid common mistakes, it is advisable to have a comprehensive understanding of lease accounting standards and best practices and stay up-to-date with any changes in accounting regulations.
Businesses should also invest in the right software, tools, and resources to identify, manage, and monitor lease arrangements and avoid errors or inaccuracies.