Quick Summary: Accounting for Leases

What is a Lease?

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                  

                              (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.

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.

 Impact of Cash flow Statement:

Total Cash Flow is the same for an Operating Lease and Finance Lease.