Leases from a Lessee’s Perspective

A finance (or capital) lease is equivalent to a lessee’s purchase of an asset that is directly financed by the lessor. An operating lease, on the other hand, 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. There  are differences, too, in the implications of each for the financial statements for the lessee and 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, instead, 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. On the lessee’s statement of cash flows, the full lease payment is shown as an operating cash outflow.

How Does This Affect Financial Statements?

A company reporting a lease as an operating lease will typically show higher profits in early years, higher return measures in early years, and a stronger solvency position than a company that reports a similar lease as a finance lease.

The company reporting the lease as a finance lease will, however, 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.

For a lessee, the main accounting distinction between a finance lease and an operating lease is that reported assets, debt and expenses are generally higher in the early years under a finance lease. For this reason, lessees often prefer operating leases to finance leases.

IFRS vs. US GAAP

IFRS and US GAAP both stipulate that appropriate disclosures be made concerning operating and finance leases. 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. The layout of disclosure notes on the debt will, however, 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 leases and finance leases are both 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.

Question 1

Which of the following statements is the most accurate?

1. Only finance leases are reported on the balance sheet.
2. The layout of disclosure notes on debt is similar across companies.
3. Disclosure notes provide information about a company’s finance leases only.

Solution

The correct answer is A.

Only finance leases are reported on the balance sheet.

B is incorrect because the layout of disclosure notes on debt varies across companies.

C is incorrect because disclosure notes provide information about all lease obligations of a company, both finance and operating leases.

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 that is directly financed by the lessor.

Solution

The correct answer is B.

The lessee reports a leased asset and lease obligation on its balance sheet in the case of a finance lease.

A is incorrect. An operating lease, not a finance lease, is economically similar to renting an asset.

C is incorrect. A finance lease, and not an operating lease, is equivalent to a lessee’s purchase of an asset that is directly financed by the lessor.