Lease Accounting Demystified | CFA Level I FSA

In this lesson, we’ll explore the world of leases, including the motivations for leasing, the different types of leases, and the accounting methods for each. We’ll also discuss the criteria for choosing the right accounting model under IFRS and US GAAP.

Leases: An Introduction

A lease is a contractual arrangement where the lessor (asset owner) allows a lessee to use the asset for a specified period in exchange for periodic payments. Companies may choose to lease assets instead of purchasing them for several reasons:

• Financing a lease can be less costly, as it usually doesn’t require an initial down payment.
• Reduced risk of obsolescence, as the asset can be returned at the end of the lease.
• More flexibility, as lease agreements can be negotiated to better suit the needs of each party.

Types of Leases: Finance vs. Operating

Leases can be classified as either finance leases (aka capital leases in the US) or operating leases:

Finance Lease: Similar to purchasing an asset financed with debt.
Operating Lease: Like a rental agreement.

Finance Lease Accounting

For the lessee, a finance lease involves the transfer of the asset to their balance sheet as a “right-of-use” asset. A liability of equal amount is also recognized to account for future lease payments. Over the lease term, the “right-of-use” asset is depreciated, and interest expense is reported in the income statement.

For the lessor, a finance lease can be treated as either a sales-type lease or a direct financing lease under US GAAP:

Sales-Type Lease: The lessor recognizes revenue, cost of goods sold, and gross profit at the inception of the lease.
Direct Financing Lease: No gross profit is recognized at the lease inception.

The lease receivable, equal to the present value of lease payments, is created in the lessor’s balance sheet. The interest income is reported in the income statement, while the principal portion of the payment reduces the lease receivable.

Operating Lease Accounting

For the lessee, an operating lease requires reporting a “right-of-use” asset and lease liability on the balance sheet. A single lease expense is recognized in the income statement, allocated straight-line over the lease term.

For the lessor, the leased asset remains on their balance sheet, and lease income is recognized in the income statement. The lessor also recognizes depreciation expense over the asset’s useful life.

Short-term leases (1 year or less) and low-value leases are exceptions, allowing the lessee to exclude the lease from their balance sheet.

Deciding Between Finance and Operating Leases

The main criterion for classifying a lease as a finance lease is the transfer of ownership benefits and risks to the lessee. Under US GAAP, lessors can classify a lease as a direct financing lease in specific cases, even if the ownership criteria aren’t met.

Under IFRS, all finance leases for lessors must be sales-type leases. Direct financing leases are not allowed. Lessees under IFRS are required to report all leases as finance leases, with the only exceptions being short-term leases (1 year or less) and low-value leases. In such cases, the lessee can exclude the lease from their balance sheet.

Key Takeaways

Here’s a summary of the differences between finance and operating leases:

• For the lessee, finance leases require separate accounting for interest expense in the income statement and cash flow statement, while operating leases have a single lease expense and lease payment.
• For the lessor, finance leases remove the asset from their balance sheet and replace it with a lease receivable, while operating leases keep the asset on their balance sheet.

We’ve also covered the different treatment of finance leases for lessors (sales-type lease and direct financing lease) and the criteria for deciding between finance and operating leases under US GAAP and IFRS.