A Lease is a contractual arrangement between the lessor,
owner of an asset and the lessee for a specific period in exchange of periodic
payments. The lease can be classified as Finance Lease and Operating Lease. In
the U.S. finance lease is also called Capital lease.
A finance lease is essentially purchase of assets using debt
as a means of financing. The lessee will recognize Assets and Liabilities both
on the balance sheet by equal amounts. The depreciation expense is recognized
over the life of an asset on the asset side of the balance sheet and interest
expense on loan is recognized in the income statement.
An operating lease is one in which lessee pays fixed amount
as lease rental, recognized as rental expense on the income statement of the
lessee. The asset remains in the books of lessor. Hence, operating leases are
also called ‘Off Balance Sheet Financing’.
When do we classify
lease as an operating or finance lease?
For a lease to be classified as finance leases any of the
following criteria should be met: - (as per US GAAP)
1) If
the ownership of an asset is transferred to the lessee after the lease term
2) If
the lease term exceeds 75% of an assets economic life
3) If
the present value of lease payments is greater than 90% of fair value of an
asset
4) If
the lessee can purchase the asset at a price which is significantly lower than
fair value of an asset at some future date
Else the lease is classified or treated as an operating
lease.
Reporting by lessee:
Example: XYZ Ltd. leases a machine for 5 years at $10000 as
lease payments which are made at the end of the year. After 5 years asset is
sold at scrap value. The appropriate interest rate is 5%. Calculate impact of
the lease on XYZ Balance sheet and income statement for each year. The asset
depreciates on SLM basis.
The above case will be classified as a finance lease as lease
term exceeds 75% of asset’s useful life (this can be inferred as after 5 years
asset will be sold at scrap value).
The asset will be recognized on XYZ Ltd. balance sheet in
present value terms of future lease payments.
Present Value = 10000 + 10000 + 10000
+ 10000 + 10000
___ _____________ ________ __________ ____________ = $42123.637
___ _____________ ________ __________ ____________ = $42123.637
(1.06) (1.06)^2 (1.06)^3
(1.06)^4 (1.06)^5
Further the
Depreciation expense each year = $42123.637/5 = $8424.72
Impact on Balance Sheet
and Profit and Loss Statement:
(All figures are in $)
As seen from the above table Interest as an expense and
depreciation will be recognized every year on XYZ Ltd. income statement. The
Book Value of an Asset will be reduced to the tune of Depreciation every year
and Liability will reduced to the tune of Principal payments.
If the above case was
treated as Operating lease then EBIT (Operating Profit) would be lower compared
to Finance Lease as EBIT will not take Interest expense into consideration and
hence Operating Profit will be higher for Finance Lease.
As seen from the above
table EBIT would be lower for Operating Lease and Net Income would be higher
for Operating Lease for early years and lower compared to finance lease during
later years.
Impact on Cash Flow
Statements:
As seen from the above table if a lease is classified as an Operating Lease Cash Flow from Operations will be lower compared to Cash Flow from Operations if the lease was classified as Finance Lease.
Summary:
Impact on Ratios:
Reporting by the Lessor:
From the lessor’s perspective, a capital lease under U.S GAAP
is treated as either sales-type lease or direct financing lease. If the present
value of the lease payments exceeds the carrying value of an asset, the lease
is treated as sales-type lease. If the present value of lease payments equals
carrying value, the lease is treated as direct financing lease.
IFRS does not distinguish between sales-type lease and direct
financing lease.
Example:
XYZ Ltd. purchases an asset whose present value equals carrying value for $69302 to lease to ABC Ltd. for 4 years with an annual lease payments of $20000 at the end of each year. At the end of the lease ABC ltd. will own the asset for no additional payments. The implied rate of interest rate is 6%. Describe how XYZ Ltd. accounts for the same.
XYZ Ltd. purchases an asset whose present value equals carrying value for $69302 to lease to ABC Ltd. for 4 years with an annual lease payments of $20000 at the end of each year. At the end of the lease ABC ltd. will own the asset for no additional payments. The implied rate of interest rate is 6%. Describe how XYZ Ltd. accounts for the same.
Since Present Value equals Carrying Value of an Asset it is
an example of Direct Financing Lease. The Lessor (XYZ Ltd.) will receive Interest
Income to the tune of 6% on Lease liability and Principal payments by ABC ltd.
As seen if the lease is classified as an Operating lease XYZ ltd. will receive periodic rentals and depreciation on Asset.
Total Cash Flow is the
same for an Operating Lease and Finance Lease.