Leases

The party who uses the asset and pays the consideration is the lessee.

The party who owns the asset, grants the right to use the asset, and receives consideration is the lessor.

Leasing is a way to obtain the benefits of the asset without purchasing it outright. From the perspective of a lessee, it is a form of financing that resembles acquiring an asset with a note payable. From the perspective of a lessor, a lease is a form of investment and can also be an effective selling strategy, because customers generally prefer to pay in installments.

Requirements for Lease Accounting

For a contract to be a lease or contain a lease, it must

• identify a specific underlying asset;
• give the customer the right to obtain largely all of the economic benefits from the asset over the contract term; and
• give the customer, not the supplier, the ability to direct how and for what objective the underlying asset is used.

Advantages of Leasing

There are several advantages to leasing an asset compared with purchasing it:

• Less cash is needed up front. Leases typically require little, if any, down payment.
• Cost effectiveness: Leases are a form of secured borrowing; in the event of non-payment, the lessor simply repossesses the leased asset. As a result, the effective interest rate for a lease is typically lower than what the lessee would pay on an unsecured loan or bond.
• Convenience and lower risks associated with asset ownership, such as obsolescence.

Lease Classification as Finance or Operating

Leases can resemble either the purchase of an asset or a rental contract.

A lease that resembles a purchase is classified as a finance lease. All other leases are operating leases.

More specifically, a lease is a finance lease if any of the following five criteria are met. These criteria are the same for IFRS and US GAAP. If none of the criteria are met, the lease is an operating lease. The same criteria are used by lessees and lessors in classifying a lease.

1. The lease transfers ownership of the underlying asset to the lessee.
2. The lessee has an option to purchase the underlying asset and is reasonably certain it will do so.
3. The lease term is for a major part of the asset’s useful life.
4. The present value of the sum of the lease payments equals or exceeds substantially all of the fair value of the asset.
5. The underlying asset has no alternative use to the lessor.

Financial Reporting of Leases

The financial reporting of a lease depends on whether the party is the lessee or lessor, whether the party reports with IFRS or US GAAP, and the classification of the lease as finance or operating. Additionally, for lessees, there are lease accounting exemptions for certain lease contracts: If its term is 12 months or less (IFRS and US GAAP) or it is for a “low-value asset,” up to USD5,000 in sales price (IFRS only), then the lessee can elect to simply expense the lease payments on a straight-line basis. These exemptions are not available to lessors.

Lessee Accounting — IFRS

The following list shows how the transaction affects the financial statements:

• The lease liability net of principal repayments and the ROU asset net of accumulated amortisation are reported on the balance sheet.
• Interest expense on the lease liability and the amortisation expense related to the ROU asset are reported separately on the income statement.
• The principal repayment component of the lease payment is reported as a cash outflow under financing activities on the statement of cash flows, and depending on the lessee’s reporting policies, interest expense is reported under either operating or financing activities on the statement of cash flows.

Lessee Accounting — US GAAP

The following list shows how the transaction appears on the financial statements:

• The lease liability net of principal repayments and the ROU asset net of accumulated amortisation are reported on the balance sheet.
• Interest expense on the lease liability and the amortisation expense related to the ROU asset are reported as a single line titled “lease expense” as an operating expense on the income statement. The interest and amortisation components are notreported separately, nor are they grouped with other types of interest and amortisation expense (e.g., interest on a bond, amortisation of an intangible asset).
• The entire lease payment is reported as a cash outflow under operating activities on the statement of cash flows. The interest and principal repayment components are not reported separately.

Lessor Accounting

The accounting for lessors is substantially identical under IFRS and US GAAP. Under both accounting standards, lessors classify leases as finance or operating leases, which determines the financial reporting. Although lessors under US GAAP recognise finance leases as either “sales-type” or “direct financing,” the distinction is immaterial from an analyst’s perspective.

The transaction affects the financial statements in the following ways:

• Lease receivable net of principal proceeds is reported on the balance sheet.
• Interest income is reported on the income statement. If leasing is a primary business activity for the entity, as it commonly is for financial institutions and independent leasing companies, it is reported as revenue.
• The entire cash receipt is reported under operating activities on the statement of cash flows.

The accounting treatment for an operating lease is different: because the contract is essentially a rental agreement, the lessor keeps the leased asset on its books and recognises lease revenue on a straight-line basis. Interest revenue is not recognised because the transaction is not considered a financing.

The transaction affects the financial statements in the following ways:

• The balance sheet is not affected. The lessor continues to recognise the leased asset at cost net of accumulated depreciation.
• Lease revenue is recognised on a straight-line basis on the income statement. Depreciation expense continues to be recognised.
• The entire cash receipt is reported under operating activities on the statement of cash flows. This is the same as a finance lease.