Deflation and Inflation Modeling
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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 be made in relation to operating and finance leases. Due to the differences between these types of leases, however, some of the disclosure requirements are dissimilar.
$$ \textbf{Lessor} \\ \begin{array}{|l|l|l|l|} \hline \begin{array}[t]{l} \textbf{Operating} \\ \textbf{Lease} \end{array} & \begin{array}[t]{l} \textbf{Retains asset on} \\ \textbf{balance sheet} \end{array} & \begin{array}[t]{l} \textbf{Reports rent} \\ \textbf{income reports} \\ \textbf{depreciation} \\ \textbf{expense} \\ \textbf{on leased asset} \end{array} & \begin{array}[t]{l} \textbf{Rent payments} \\ \textbf{received are} \\ \textbf{an operating} \\ \textbf{cash inflow} \end{array} \\ \hline \begin{array}[t]{l} \text{When present} \\ \text{value of lease} \\ \text{payments equals} \\ \text{the carrying} \\ \text{amount of the} \\ \text{leased asset} \\ \text{(called a direct} \\ \text{financing} \\ \text{lease in} \\ \text{US GAAP)} \end{array} & \begin{array}[t]{l} \text{Removes asset} \\ \text{from the balance} \\ \text{sheet and} \\ \text{recognizes} \\ \text{lease} \\ \text{receivables} \end{array} & \begin{array}[t]{l} \text{Reports interest} \\ \text{revenue on} \\ \text{lease} \\ \text{receivables} \end{array} & \begin{array}[t]{l} \text{The interest} \\ \text{portion of the} \\ \text{lease payment} \\ \text{received is either} \\ \text{an operating or} \\ \text{an investing cash} \\ \text{inflow under} \\ \text{IFRS and an} \\ \text{operating cash} \\ \text{inflow under} \\ \text{US GAAP. The} \\ \text{receipt of the} \\ \text{lease principal} \\ \text{is an investing} \\ \text{cash inflow} \end{array} \\ \hline \begin{array}[t]{l} \text{When present} \\ \text{value of lease} \\ \text{payments exceeds} \\ \text{the carrying} \\ \text{amount of the} \\ \text{leased asset} \\ \text{(called a sales} \\ \text{type lease} \\ \text{under} \\ \text{US GAAP)} \end{array} & \begin{array}[t]{l} \text{Removes asset} \\ \text{and recognizes} \\ \text{lease} \\ \text{receivables} \end{array} & \begin{array}[t]{l} \text{Reports profit} \\ \text{on sale and} \\ \text{reports interest} \\ \text{revenue on} \\ \text{lease} \\ \text{receivables} \end{array} & \begin{array}[t]{l} \text{The interest} \\ \text{portion of the} \\ \text{lease payment} \\ \text{received is either} \\ \text{an operating or} \\ \text{an investing cash} \\ \text{inflow under} \\ \text{IFRS and an} \\ \text{operating cash} \\ \text{inflow under} \\ \text{US GAAP. The} \\ \text{receipt of the} \\ \text{lease principal} \\ \text{is an investing} \\ \text{cash inflow} \end{array} \\ \hline \end{array} $$
a 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.
b If providing leases is part of a company‘s normal 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:
- Keep ownership of the asset and report the asset’s depreciation.
- Keep ownership of the asset but the lessee would be required to report the asset’s depreciation.
- 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.
Under an operating lease contract, a lessor would keep ownership of the asset. Therefore, the lessor, not the lessee, would be required to report the asset’s depreciation.