Lease contracts play an important role in the day-to-day of most organizations. But does your business thoroughly understand each party’s responsibilities? What about the benefits? These answers are critical to maintaining accurate and healthy lease accounting.

Who are the lessor and lessee in a contract?

Under a contractual lease obligation — be it commercial real estate, equipment or vehicles — there is always a lessor and a lessee. A lease is generally defined as a contractual arrangement in which one party, the lessor, provides an asset for use by the other party, the lessee. This arrangement is based on periodic payments for an agreed amount of time.

Lessor vs. lessee: A closer look at the benefits

The lessor is an entity or individual who retains the right of ownership of a leased asset. The lessor is also entitled to receive periodic payments from the lessee based on their agreement.

Renting out the asset allows the lessor to earn income and, in certain cases, profit from the asset’s appreciation over a period of time. Although the lessor retains ownership of the asset, they have reduced rights to it during the course of the lease agreement.

The lessee, on the other hand, is the party who has the right to use an asset for a specific amount of time and makes periodic payments to the lessor based on their agreement. The length of the lease period often depends at least partially on the type of asset or property. By renting the asset, lessees can use it without an outright purchase or a substantial down payment.

Both parties have the right to terminate the lease for a breach of contract.

How to approach accounting for leases as a lessor or lessee

Although different types of leases exist — such as finance and operating leases — the obligations have one thing in common. When it comes to lease accounting, leases must be reported accurately to meet regulatory compliance standards.

Lessor accounting obligations

Accurate accounting is vital to the health of any organization. As a lessor, accounting accuracy requires correctly classifying your leases—whether as sales-type, direct financing or operating.

Under lease accounting standard ASC 842, ownership transfers to the lessee for accounting purposes for sales-type and direct financing leases. Sales-type leases require lessors to derecognize the underlying asset and instead recognize the lease’s net investment, selling profit or loss arising from the lease, and track the balance and interest income over time. Lessors record direct financing leases in a similar manner but defer the asset’s profit or loss.

Operating leases give the lessee the right to use the asset but not ownership of it. Therefore, lessors record the asset, its related depreciation and lease payments in the books.

Lessee accounting obligations

Lessees must classify their leases as either finance or operating under the ASC 842 lease accounting standard. Both types of leases must appear in the organization’s balance sheet unless the term is 12 months or less, which is considered a short-term lease. For operating leases, lessees are expected to record payments as operating costs on the organization’s income statement.

Whether you are a lessor or a lessee, using a robust software solution like Visual Lease can help maintain accurate lease accounting — and protect the financial health of your business.