Financial Reporting of Leases

Non-current liabilities include diverse sources of financing and different types of creditors. They include bonds, loans, leases, and post-employment liabilities such as defined contribution, defined benefit, and stock-based compensation plans.

Lease Contract

A lease is a contract between a lessor, the owner of an asset, and a lessee, the other party seeking to use the asset. Through a lease, the lessor grants the lessee the right to use the asset. In exchange for the right to use the asset, the lessee makes periodic lease payments to the lessor.

For a contract to contain a lease or be a lease, it must:

1. identify a specific underlying asset.
2. give the customer, not the supplier, the ability to direct how and for what purpose the underlying asset is used.
3. grant the customer the right to obtain substantially all of the economic benefits from the asset over the contract term.

Consider this example. If a customer contracts with an equipment rental company for a specific piece of machinery, has exclusive use during the contract term, and controls its use, it is considered a lease. However, if the contract is for general equipment services without specifying a particular machine and the rental company controls the equipment, it is not a lease.

Advantages of Leasing an Asset Compared to Buying

From the lessee’s perspective, there are several advantages to leasing an asset compared to purchasing it:

• Less cash needed upfront: Leases usually require little to no down payment.
• Cost-effectiveness: Leases are a form of secured borrowing, allowing the lessor to repossess the asset if payments are not made. This often results in a lower effective interest rate compared to unsecured loans or bonds.
• Convenience and reduced ownership risks: Leasing mitigates risks such as obsolescence.

On the other, from the lessor’s perspective, leasing offers advantages over outright sales, including:

• earning interest income over the lease term and
• expanding the market by allowing customers to use an asset with smaller, periodic payments.

Classifying Lease Agreements

Leases can resemble either the purchase of an asset or a rental contract. Leases that resemble purchases are classified as finance leases, while all other leases are considered operating leases.

For instance, a five-year lease of industrial equipment with a five-year useful life, where the total lease payments are equal to or greater than the equipment’s fair value, functions as a finance lease. In contrast, a two-year lease of office space in a building with a thirty-year useful life resembles an operating lease.

Formally, a lease is classified as a finance lease if any of the following five criteria are met under both IFRS and US GAAP, used by both lessees and lessors:

1. The lease transfers ownership of the underlying asset to the lessee.
2. The lessee has an option to purchase the underlying asset and is reasonably certain to do so.
3. The lease term covers a major part of the asset’s useful life.
4. The present value of the lease payments equals or exceeds significantly the asset’s fair value.
5. The underlying asset has no alternative use to the lessor.

If none of the above criteria are met, the lease is classified as an operating lease.

Example: Lease Identification and Classification

Company M enters into an agreement with Company N that obligates Company M to pay USD200,000 at the end of each of the next three years to Company N for the exclusive use of a specialized vehicle over that time period. The present value of the payments is USD 540,000. At the end of the agreement, Company M will return the vehicle to Company N. The agreement does not include a purchase provision. Moreover, the vehicle can be utilized by different clients in various industries. The remaining useful life of the vehicle is seven years, and its fair value is USD 550,000.

Question 1: Which type of lease contract is described above?

Solution

Given the above information, the lease contract between companies M and N is a finance lease because the present value of the lease payments amounts to nearly the entire fair value of the asset (540/550 ≈ 98%), which satisfies the fourth criteria (The present value of the lease payments equals or exceeds significantly the asset’s fair value

Question 2: If the vehicle’s fair value was USD 1,000,000, would the lease agreement’s classification change?

Solution
With the change of the fair value, the lease would not satisfy any of the five criteria for a finance lease. If none of the criteria are met, the lease must be classified as an operating lease.

Financial Reporting of Leases

The financial reporting of a lease depends on several factors:

• whether the party is the lessee or lessor,
• whether IFRS or US GAAP standards are used, and
• whether the lease is classified as finance or operating.

Moreover, lessees have certain accounting exemptions for specific lease contracts. Specifically, in both IFRS and US GAAP, lease accounting exemptions apply if the lease term is 12 months or less. Additionally, in IFRS only, if the lease involves a “low-value asset” up to USD 5,000 in sales price, the lessee can opt to expense the lease payments on a straight-line basis. Note that these exemptions do not apply to lessors.

Lessee Accounting under IFRS and US GAAP

Under IFRS

Under IFRS, lessees follow a single accounting model for both finance and operating leases. At the start of the lease, the lessee records a lease liability and a right-of-use (ROU) asset on the balance sheet, both valued at the present value of future lease payments. The discount rate applied in this calculation is either the rate implicit in the lease or an estimated secured borrowing rate.

The lease liability is subsequently decreased with each lease payment using the effective interest method. Each lease payment consists of two parts: interest expense, calculated as the product of the lease liability and the discount rate, and principal repayment, which is the difference between the lease payment and the interest expense.

The ROU asset is amortized, usually on a straight-line basis, over the lease term. While the lease liability and the ROU asset start with the same carrying value, they diverge over time because the principal repayment that reduces the lease liability and the amortization expense that reduces the ROU asset are calculated differently.

The impact on the financial statements is as follows:

• The balance sheet shows the lease liability, net of principal repayments, and the ROU asset, net of accumulated amortization.
• The income statement separately reports interest expense on the lease liability and amortization expense related to the ROU asset.
• The statement of cash flows reports the principal repayment component of the lease payment as a cash outflow under financing activities. Depending on the lessee’s reporting policies, interest expense is reported under either operating or financing activities.

Example: Demonstrating Lessee Accounting under IFRS
Titan Manufacturing, a fictional company based in France, agrees to lease equipment under the following terms: a four-year lease with an implied interest rate of 8 percent and an annual lease payment of EUR90,000, payable at the end of each year. The asset will be amortized over the four-year lease term on a straight-line basis. If Titan reports under IFRS, discuss the effect of this lease on Titan’s balance sheet, income statement, and statement of cash flows.

Solution

Impact on the Balance Sheet:

Using the BA II Plus financial calculator, the present value of the equipment is approximately EUR298,091 (N=5, I/Y=8, PMT=90,000, FV=0 CPT PV=298,091.4156). As such, Titan would report a EUR298,091 lease liability and a right-of-use (ROU) asset (leased equipment).

Impact on Income Statement:

Consider the following lease payment and amortization schedules:

$$\begin{align}
&\textbf{Lease Payment Schedule} \\
&\begin{array}{l|c|c|c|c}
\textbf{Year} & \textbf{Lease Payment} & \textbf{Interest Expense} & \textbf{Principal Repayment} & \textbf{Lease}\\
& & \text{(8% × Lease Liability)} & \text{(Payment – Interest)} &\text{Liability} \\
& \text{(EUR)} & \text{(EUR)} & \text{(EUR)} & \text{(EUR)} \\
\hline
0 & & & & 298,091 \\
\hline
1 & 90,000 & 23,847 & 66,153 & 231,938 \\
\hline
2 & 90,000 & 17,859 & 72,141 & 159,797 \\
\hline
3 & 90,000 & 12,784 & 77,216 & 82,581 \\
\hline
4 & 90,000 & 6,606 & 83,394 & 0 \\
\hline
\textbf{Total} & \textbf{360,000} & \textbf{61,096} & \textbf{298,091} & \\
\end{array}\\&\\&\\&\textbf{Amortization Schedule}\\&\begin{array}{l|c|c}
\textbf{Year} & \textbf{Amortization Expense (EUR)} & \textbf{ROU Asset (EUR)} \\
\hline
0 & & 298,091 \\
\hline
1 & 74,523 & 223,568 \\
\hline
2 & 74,523 & 149,045 \\
\hline
3 & 74,523 & 74,522 \\
\hline
4 & 74,523 & 0 \\
\textbf{Total} & \textbf{298,091} & \\\end{array}\end{align}$$

Recall that interest expense and amortization expense are reported on the income statement. For instance, from the tables above, notice that in year 2, interest expense is EUR17,859, amortization expense is EUR74,523, and so on.

Impact on the Statement of Cashflows:

From the discussion above, principal repayments are reported as a cash outflow under financing activities on the statement of cash flows. Moreover, depending on Titan’s reporting policies, interest expense is reported under operating or financing activities on the statement of cash flows.

Specifically from the table, Year 2 principal repayment is EUR72,141, and interest expense is EUR17,859, for a total of EUR90,000 (values for other years are shown as well).

Under US GAAP

Under US GAAP, lessees have two accounting models: one for finance leases and another for operating leases. The finance lease accounting model mirrors the lessee accounting model under IFRS. However, the operating lease accounting model differs.

At the inception of an operating lease, the lessee records both a lease payable liability and a corresponding right-of-use (ROU) asset on the balance sheet. Similar to IFRS lessees, these are reduced by the principal repayment component of the lease payment and amortization, respectively. The main difference between an operating lease and a finance lease lies in calculating the ROU asset amortization.

For operating leases, the ROU asset amortization expense is calculated as the lease payment minus the interest expense. This results in the total expense reported on the income statement (interest plus amortization) equaling the lease payment and the lease liability and ROU asset remaining equal because the principal repayment and amortization are calculated similarly.

The effects on the financial statements are as follows:

• The balance sheet shows the lease liability net of principal repayments and the ROU asset net of accumulated amortization.
• On the income statement, interest expense on the lease liability and the amortization expense related to the ROU asset are reported together as “lease expense” under operating expenses. These components are not reported separately or combined with other types of interest and amortization expenses.
• The entire lease payment is reported as a cash outflow under operating activities on the statement of cash flows, with interest and principal repayment components not separated.

Example: Demonstrating Lessee Accounting under US GAAP

Assume that Titan Manufacturing is reporting under US GAAP and that we are dealing with an operating lease. The amortization and lease schedule is as follows:

$$\begin{align}
&\begin{array}{l|c|c|c}
\textbf{Year} & \textbf{Amortization Expense} & \textbf{ROU Asset} & \textbf{Lease Expense} \\
& & & \text{(Amortization + Interest)} \\
& \text{(EUR)} & \text{(EUR)} & \text{(EUR)} \\
\hline
0 & & 298,091 & \\
\hline
1 & 66,153 & 231,938 & 90,000 \\
\hline
2 & 72,141 & 159,797 & 90,000 \\
\hline
3 & 77,216 & 82,581 & 90,000 \\
\hline
4 & 83,394 & 0 & 90,000 \\
\hline
\textbf{Total} & \textbf{298,091} & & \textbf{360,000} \\
\end{array}
\end{align}$$

From the table above:

• the lease liability net of principal repayments and the ROU asset net of accumulated amortization for years 1,2,3 and 4 are equal at EUR 231,938, EUR 159,797, EUR 82,581, and EUR 0 (reported on the balance sheet).
• lease expense remains constant at EUR 90,000 each year for four years (Reported on the income statement)
• EUR 90,000 is reported annually (for four years) as the cash flow from operating activities.

Lessor Accounting under IFRS and US GAAP

Lessor accounting is largely identical under both IFRS and US GAAP. Lessors classify leases as either finance or operating leases, which determines the financial reporting. While US GAAP distinguishes between “sales-type” and “direct financing” leases, this distinction does not have a significant effect on analysis.

Finance Lease

At the inception of a finance lease, the lessor recognizes a lease receivable equal to the present value of future lease payments and derecognizes the leased asset, simultaneously recognizing any difference as a gain or loss. The discount rate used in the present value calculation is implicit in the lease.

The lease receivable is subsequently reduced by each lease payment using the effective interest method. Each lease payment consists of interest income, which is the product of the lease receivable and the discount rate, and principal proceeds, which is the difference between the interest income and the cash received.

The transaction affects the financial statements in the following ways:

• Balance Sheet: The lease receivable net of principal proceeds is reported.
• Income Statement: Interest income is reported. If leasing is a primary business activity, it is reported as revenue.
• Statement of Cash Flows: The entire cash receipt is reported under operating activities.

Operating Lease

The accounting treatment differs for operating leases because the contract is essentially a rental agreement. The lessor retains the leased asset on its books and recognizes lease revenue on a straight-line basis. Interest revenue is not recognized since the transaction is not considered financing.

The transaction affects the financial statements in the following ways:

• Balance Sheet: The lessor continues to recognize the leased asset at cost net of accumulated depreciation.
• Income Statement: Lease revenue is recognized on a straight-line basis. Depreciation expense continues to be recognized.
• Statement of Cash Flows: The entire cash receipt is reported under operating activities.

Question 1

Under an operating lease contract, a lessor would most likely:

1. Keep ownership of the asset and report the asset’s depreciation.
2. Keep ownership of the asset, but the lessee must report the asset’s depreciation.
3. Transfer ownership of the asset to the lessee but revoke ownership transfer if the lessee does not fulfill its contractual obligations.

Solution

The correct answer is A.

In an operating lease agreement, the lessor retains ownership of the leased asset and is responsible for any depreciation on the asset. The lessee simply uses the asset for a specified period, and at the end of the lease term, the asset is returned to the lessor. The lessee does not report depreciation for the asset; instead, they account for the lease payments as an operating expense over the lease term.

Question 2

Which of the following statements is the most accurate?

1. A finance lease is economically similar to renting an asset.
2. In a finance lease, the lessee reports a leased asset and lease obligation on its balance sheet.
3. An operating lease is equivalent to a lessee’s purchase of an asset directly financed by the lessor.

Solution

The correct answer is B.

In a finance lease, the lessee recognizes the right-of-use asset and the corresponding lease liability on its balance sheet. This accounting treatment reflects the economic reality that the lessee has control over the asset and is obligated to make lease payments.

A is incorrect. Finance lease is more similar economically to purchasing an asset than renting, as the lessee assumes both the benefits and risks of ownership.

C is incorrect. An operating lease does not equate to an asset purchase by the lessee. The lessor retains ownership of the asset in an operating lease, and the lessee does not record the asset on its balance sheet (under traditional operating lease accounting).