Financial Reporting of Leases

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. Have a specific underlying asset.
2. Give the customer the ability to stipulate for what purpose and how the underlying asset is used.
3. Give the customer the right to derive all economic benefits from the asset over the term of the contract.

Advantages of leasing an asset

• Leases can provide less costly financing for the lessee than purchases. They usually require little, if any, down payment and often go at lower fixed interest rates than those that would otherwise be incurred if the asset was purchased.
• The lessor may be better positioned to take advantage of tax benefits of ownership, such as depreciation and interest.
• The lessor enhances their ability to value and bear the risks associated with ownership, such as obsolescence, residual value, and disposition of an asset.
• The lessor may enjoy economies of scale for servicing assets.
• A negotiated lease contract may contain less restrictive provisions than other forms of borrowing.

Lessee’s Perspective

A finance (or capital) lease is equivalent to a lessee’s purchase of an asset directly financed by the lessor. On the other hand, an operating lease is an agreement that allows a lessee to use an asset for a period of time.

The economic substance of a finance lease is very different from that of an operating lease. Each type of lease also carries implications for financial statements for both the lessee and the lessor.

Finance Lease vs. Operating Lease

Under IFRS, the classification of a lease, either as a finance lease or an operating lease, is dependent on the transfer of the risks and rewards that are incidental to ownership of the leased asset.

If all the risks and rewards are substantially transferred to the lessee, the lease is classified as a finance lease, and the lessee will report the leased asset and lease obligation on its balance sheet. Otherwise, the lease will be reported as an operating lease, in which case the lessee reports neither an asset nor a liability but only reports the lease expense.

Finance Lease

A finance lease is economically similar to borrowing money and buying an asset. As a result, a company that enters into a finance lease, as the lessee, reports the leased asset and related debt (lease payable) on its balance sheet. On the income statement, the lessee reports interest expense on the debt, and if the acquired asset is depreciable, depreciation expense is also reported. The lessor will report the sale of an asset and a lease as a receivable.

For a finance lease, only the portion of the lease payment relating to interest expense potentially reduces the operating cash flow. The portion of the lease payment that reduces the lease liability appears as a cash outflow in the financing section.

Operating Lease

An operating lease is economically similar to renting an asset. As a result, a company that enters into an operating lease, as the lessee, will record a lease expense on its income statement during the period within which it uses the asset. No asset or liability will be recorded on its balance sheet. The lease payment is shown as an operating cash outflow on the lessees’ statement of cash flows.

How Does This Affect Financial Statements?

A company reporting a lease as an operating lease will typically show higher profits in the early years and a more robust solvency than a company reporting a similar lease as a finance lease.

However, the company reporting the lease as a finance lease will show higher operating cash flows because the portion of the lease payment that reduces the carrying amount of the lease liability will be reflected as a financing cash outflow rather than an operating cash outflow.

In a finance lease, a lessee reports the leased asset and corresponding liability on their balance sheet. This scenario leads to higher reported assets and debt. The lessee will also recognize both depreciation and interest expenses, which could result in higher expenses in the early years of the lease.

In contrast, with an operating lease, lessees traditionally did not report the leased asset and liability on their balance sheet. They only recognized the lease payments as an expense evenly over the lease term, which could lead to lower reported assets, liabilities, and expenses especially in the early years of the lease. This accounting treatment distinction is why lessees might prefer operating leases, as they may result in more favorable financial ratios and appear less burdensome on the balance sheet and income statement, particularly in the early lease years.

However, note that recent updates to accounting standards, specifically IFRS 16 and ASC 842, now require the recognition of assets and liabilities for operating leases, altering this traditional distinction.

IFRS vs. US GAAP

IFRS and US GAAP stipulate that appropriate disclosures concerning operating and finance leases should be made. Due to the differences between these types of leases, however, some of the disclosure requirements are dissimilar.

In the case of finance leases, IFRS requires the balance sheet to present finance lease obligations in the line items labeled “Debt.”

IFRS also requires certain disclosures to be made in the notes. However, the layout of disclosure notes on the debt will vary across companies. Usually, the notes provide:

• A breakdown of the total debt reported on the balance sheet into two components: the amount of debt excluding finance lease obligations and the amount of finance lease obligations;
• Disclosures on the component of on-balance-sheet debt, excluding finance lease obligations and
• Information about all the lease obligations of a company, both finance and operating leases, including the present and future value of minimum finance lease payments.

Even though operating and finance leases are contractual obligations, only finance leases are reported on the balance sheet.

For operating leases, the disclosure notes will provide information on the commitments due to operating lease contracts, i.e., the nominal value of the future minimum payments and their maturity dates.

Lessors Perspective

If the lessor substantially transfers all the risks and rewards incidental to legal ownership, the lease is reported as a finance lease. Consequently, the lessor reports a lease receivable on its balance sheet and removes the leased asset from its balance sheet. Otherwise, if the lease is reported as an operating lease, the lessor keeps the leased asset on its balance sheet.

Both IFRS and US GAAP stipulate that appropriate disclosures concerning operating and finance leases should be made. Due to the differences between these types of leases, however, some of the disclosure requirements are dissimilar.

$$ \textbf{Lessor} \\
\begin{array}{l|l|l}
\textbf{Operating Lease} & {\text{Retains assets on} \\ \text{the balance sheet.}} & {\text{Reports rent} \\ \text{income reports} \\ \text{depreciation} \\ \text{expense on the} \\ \text{leased asset.}} & {\text{Rent payments} \\ \text{received are an} \\ \text{operating cash} \\ \text{inflow.}} \\ \hline
{\text{When the present} \\ \text{value of lease} \\ \text{payments equals} \\ \text{the carrying} \\ \text{amount of the} \\ \text{leased asset (called} \\ \text{a direct financing} \\ \text{lease in US GAAP).}} & {\text{Removes assets} \\ \text{from the balance} \\ \text{sheet and} \\ \text{recognizes lease} \\ \text{receivables.}} & {\text{Reports interest} \\ \text{revenue on lease} \\ \text{receivables.}} & {\text{The interest} \\ \text{portion of the lease} \\ \text{payment received} \\ \text{is either an} \\ \text{operating or an} \\ \text{investing cash} \\ \text{inflow under IFRS} \\ \text{and an operating} \\ \text{cash inflow under} \\ \text{US GAAP. The} \\ \text{receipt of the lease} \\ \text{principal is an} \\ \text{investing cash} \\ \text{inflow.}} \\ \hline
{\text{When the present} \\ \text{value of lease} \\ \text{payments exceeds} \\ \text{the carrying} \\ \text{amount of the} \\ \text{leased asset (called} \\ \text{a sales-type lease} \\ \text{under US GAAP).}} & {\text{Removes assets} \\ \text{and recognizes} \\ \text{lease receivables.}} & {\text{Reports profit on} \\ \text{sale and reports} \\ \text{interest revenue on} \\ \text{lease receivables.}} & {\text{The interest} \\ \text{portion of the lease} \\ \text{payment received} \\ \text{is either an} \\ \text{operating or an} \\ \text{investing cash} \\ \text{inflow under IFRS} \\ \text{and an operating} \\ \text{cash inflow under} \\ \text{US GAAP. The} \\ \text{receipt of the lease} \\ \text{principal is an} \\ \text{investing cash} \\ \text{inflow.}}
\end{array} $$

1. US GAAP distinguishes between a direct financing lease and a sales-type lease, but IFRS does not. The accounting is the same for IFRS and US GAAP despite this additional classification under US GAAP.
2. If providing leases is part of a company’s regular business activity, the cash flows related to the leases are classified as operating cash.

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 because a 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 because 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).