Classification of lease agreements in accounting terms

This article answers the following questions:

• How should lease agreements be recognised in accounting books?
• How should the useful life of a leased asset be determined?

Leasing is a unique form of financing that enables companies to use assets without purchasing them. Its growing popularity means that many entrepreneurs are increasingly analysing the advantages and disadvantages of this form of financing, also in the context of tax costs. However, a very important – yet frequently overlooked – issue is the proper identification of the type of lease for accounting purposes. What should accountants pay attention to in such cases?

Finance leases (and more) under accounting law

Entrepreneurs may have both positive and negative opinions about the current regulations. In general, the more universal the regulations (designed for the broadest possible group of entities), the more room they leave for interpretation – or even overinterpretation. And this is precisely the situation here.

While the criteria set out in Article 3(4) of the Accounting Act, additionally supported by National Accounting Standard No. 5 “Leases, Tenancy and Leasehold” (NAS 5), provide very helpful guidance for classifying a lease agreement as a finance lease or operating lease, proper interpretation of these provisions can prove to be quite a challenge.

How to classify a lease?

So, how should companies recognise lease agreements in their accounting books? Let us look at some of the questions our clients commonly ask us as statutory auditors during audits of financial statements or consultations:

• How should an accountant determine three‑quarters of the economic useful life of a leased asset? Should they consider the expected period of use in a given entity, or the general useful life of the asset? Should they refer to the entity’s accounting policy in this respect? And how does the economic useful life relate to the lease term?
• How should an entrepreneur determine the discount rate – especially in times of changing money value – in order to assess the future value of the agreement?
• Is a potential penalty for early termination of the contract material or not?

These and other issues can cause sleepless nights – after all, determining the type of lease affects the balance sheet total, and not all companies wish to increase it (for various reasons).

Lease accounting step by step

Lease accounting derives directly from the applicable regulations and – drawing from our audit experience – we will focus on their interpretation. To make the process as straightforward as possible, each note in this series will address a single, specific criterion to consider when classifying leases for accounting purposes. We will begin with determining the useful life of the leased asset.

Before we embark on this journey through the intricacies of Polish accounting regulations on leasing, we encourage you to explore our series of articles dedicated to leasing under international standards.

The creators of international standards opted for maximum simplification of how lease agreements are treated. However, for now, there is no indication that Polish regulations will follow this path. Therefore, we present a collection of practical solutions to support you in addressing the most common issues and challenges. And should this not be enough – we invite you to contact us.