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j Game Center explain the financial reporting of leases from the perspectives of lessors and lessees

e Discussions Firms typically acquire the rights to use assets by outright purchase. As an alternative, a lease is a contract
that conveys the right to use an asset for a period of time in exchange for consideration. The party who uses
B Search
the asset and pays the consideration is the lessee, and 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.

After reviewing the contractual requirements for a lease, this lesson examines the advantages and
classification of leases and their financial reporting.

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.

For example, a contract between a customer and a trucking company is a lease if the contract identifies a
specific truck, allows the customer exclusive use of it during the contract term, and lets the customer direct
its use. If, however, the customer contracts with a trucking company to ship goods for a fee, the contract
would not be a lease, because a specific truck is not identified nor does the customer obtain largely all of the
economic benefits from the truck over the contract term.

Examples of Leases
Leasing is among the most prevalent forms of financing. Most companies are lessees of real estate and
information technology assets. In 2014, the International Accounting Standards Board found that more than
14,000 publicly listed companies were lessees and that they owed more than USD3.3 trillion in future lease
payments in aggregate.1Exhibit 1 illustrates several examples of these arrangements.

Exhibit 1: Examples of Leases

Lessee Lease Disclosure Excerpt

Alibaba “The Company entered into operating lease agreements primarily for shops and malls, offices,
warehouses, and land.”
Copa “The Company leases some aircraft under long-term lease agreements with an average
Airlines duration of 10 years. Other leased assets include real estate, airport and terminal facilities,
sales offices, maintenance facilities, and general offices.”
Meta “We have entered into various non-cancelable operating lease agreements for certain of our
(formerly offices, data center, land, colocations, and equipment.”
Facebook)
Standard “The group leases various offices, branch space, and ATM space.”
Bank
Sources: Companies’ 2020 and 2019 annual reports.

Lessors are often real estate investment companies or banks, although there are independent specialist
leasing companies, such as AerCap Holdings N.V., which describes itself as “the global leader in aircraft
leasing.” As of 30 June 2022, the company owned 1,557 passenger aircraft that are leased to airlines.2

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.3

From the perspective of a lessor, leasing has advantages over selling outright, which include earning interest
income over the lease term and increasing the addressable market for its product by offering customers the
ability to use or control an asset while paying smaller amounts over time.

Lease Classification as Finance or Operating

Leases can resemble either the purchase of an asset or a rental contract. For example, a ten-year lease of
an automobile with a ten-year useful life for monthly payments that, in aggregate, are equal to or greater
than the fair value of the automobile is effectively a debt-financed purchase of that automobile. In contrast, a
one-year lease of a machine with a twenty-year useful life resembles 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.

EXAMPLE 1

Lease Identification and Classification

Company C enters a contract with Company D that requires Company C to pay JPY100 million at the
end of each of the next two years to Company D for exclusive use of a specific machine over that time
period. The present value of the payments is JPY186 million. At the end of the contract, Company C
will return the machine to Company D. The contract does not contain a purchase option. The machine
can be used in many applications by many types of customers. The remaining useful life of the
machine is four years, and its fair value is JPY190 million.

1. This contract is:

A. not a lease.
B. an operating lease.
C. a finance lease.

Hide Solution

Solution:

C is correct. This contract is a lease because a specific asset is identified, Company C will
exclusively use it, and Company C will have the ability to direct its use. The contract is a finance
lease because one of the five criteria is met: The present value of the lease payments equals
substantially all of the fair value (186/190 = 98%).

2. If the fair value of the machine in question 1 was JPY300 million, would the classification of the
contract change?

A. No
B. Yes, from an operating lease to a finance lease
C. Yes, from a finance lease to an operating lease

Hide Solution

Solution:

C is correct. This change would result in the lease not meeting any of the five criteria for a
finance lease. If a lease does not meet any of the five criteria, it is an operating lease.

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. Exhibit 2 illustrates the different permutations for lease accounting.

Exhibit 2: Lease Classifications for Lessee and Lessor

Fortunately, lessor accounting under both IFRS and US GAAP is substantially identical, and the differences
in treatment for lessees are modest.

Lessee Accounting—IFRS
Under IFRS, there is a single accounting model for both finance and operating leases for lessees. At lease
inception, the lessee records a lease payable liability and a right-of-use (ROU) asset on its balance sheet,
both equal to the present value of future lease payments. The discount rate used in the present value
calculation is either the rate implicit in the lease or an estimated secured borrowing rate.

The lease liability is subsequently reduced by each lease payment using the effective interest method. Each
lease payment is composed of interest expense, which is the product of the lease liability and the discount
rate, and principal repayment, which is the difference between the interest expense and lease payment.

The ROU asset is subsequently amortized, often on a straight-line basis, over the lease term. So, although
the lease liability and ROU asset begin with the same carrying value on the balance sheet, they typically
diverge in subsequent periods because the principal repayment that reduces the lease liability and the
amortization expense that reduces the ROU asset are calculated differently.

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 amortization are
reported on the balance sheet.
Interest expense on the lease liability and the amortization 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.

EXAMPLE 2

Lease Impact on Balance Sheet and Income Statement

Proton Enterprises, a hypothetical manufacturer based in Germany, is offered the following terms to
lease a machine: five-year lease with an implied interest rate of 10 percent and an annual lease
payment of EUR100,000 per year payable at the end of each year. The present value of the machinery
is therefore EUR379,079 (in Microsoft Excel, the formula is =PV(10%,5,-100,000). The asset will be
amortized over the five-year lease term on a straight-line basis. Proton reports under IFRS.

1. What would be the impact of this lease on Proton’s balance sheet at the beginning of the year?

Hide Solution

Solution:

Proton would report a EUR379,079 lease liability and ROU asset.

2. What would be the impact of this lease on Proton’s income statement during the following year?

Hide Solution

Solution:

Interest expense and amortization expense are reported on the income statement. In Year 2,
interest expense is EUR31,699 and amortization expense is EUR 75,816, as illustrated in the
following tables:

Interest Expense Principal Repayment

Lease Payment (10% × Lease Liability) (Payment – Interest) Lease Liability

FO.1 FO.2 FO.3 FO.4

Year 0 379,079
Year 1 100,000 37,908 62,092 316,987
Year 2 100,000 31,699 68,301 248,685
Year 3 100,000 24,869 75,131 173,554
Year 4 100,000 17,355 82,645 90,909
Year 5 100,000 9,091 90,909 0
Total 500,000 120,921 379,079

Amortization Expense ROU Asset

Straight-Line F.1 F.2

Year 0 379,079
Year 1 75,816 303,263
Year 2 75,816 227,447
Year 3 75,816 151,631
Year 4 75,816 75,816
Year 5 75,816 0
Total 379,079

Note: Totals may not sum due to rounding.

3. What would be the impact of this lease on Proton’s statement of cash flows during the following
year?

Hide Solution

Solution:

Principal repayments are reported as a cash outflow under financing activities on the statement
of cash flows, and depending on Proton’s reporting policies, interest expense is reported under
operating or financing activities on the statement of cash flows. From the previous tables, Year 2
principal repayment is EUR68,301 and interest expense is EUR31,699, for a total of
EUR100,000.

Lessee Accounting—US GAAP

Under US GAAP, there are two accounting models for lessees: one for finance leases and another for
operating leases. The finance lease accounting model is identical to the lessee accounting model for IFRS.
The operating lease accounting model is different.

At operating lease inception, the lessee records a lease payable liability and a corresponding right-of-use
asset on its balance sheet that are subsequently reduced by the principal repayment component of the lease
payment and amortization, respectively, in the same manner that an IFRS lessee would.

The key difference between an operating lease and a finance lease is how the amortization of the ROU
asset is calculated. For an operating lease, the lessee’s ROU asset amortization expense is the lease
payment minus the interest expense. The implication is that the total expense reported on the income
statement (interest plus amortization) will equal the lease payment and that the lease liability and the ROU
asset will always equal each other because the principal repayment and amortization are calculated in an
identical manner.

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 amortization are
reported on the balance sheet.
Interest expense on the lease liability and the amortization 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 amortization components are not reported separately, nor are they grouped with other types
of interest and amortization expense (e.g., interest on a bond, amortization 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.

EXAMPLE 3

Lessee Accounting—Operating Lease under US GAAP

Consider the differences in accounting if Proton Enterprises classified the lease of the machinery from
Example 2 as an operating lease.

1. How would its financial statements differ, if at all?

Hide Solution

Solution:

The first step is to construct the lease liability and ROU asset amortization tables under an
operating lease scenario. The lease liability amortization is the same as the finance lease
columns FO.1–FO.4 in Example 2.

Amortization Expense Lease Expense

(Lease Payment – Interest) ROU Asset (Amortization + Interest)

0.1 0.2 0.3

Year 0 379,079
Year 1 62,092 316,987 100,000
Year 2 68,301 248,685 100,000
Year 3 75,131 173,554 100,000
Year 4 82,645 90,909 100,000
Year 5 90,909 0 100,000
Total 379,078 500,000

Now we can compare the financial statement impacts under both finance and operating lease
scenarios.

Balance Sheet Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
ROU asset, net: F.2 303,263 227,447 151,631 75,816 0
Lease liability, net: FO.4 316,987 248,685 173,554 90,909 0
Operating lease:
ROU asset, net: O.2 316,987 248,685 173,554 90,909 0
Lease liability, net: FO.4 316,987 248,685 173,554 90,909 0

The ROU asset is lower in each period under a finance lease because the amortization expense
is higher.

Income Statement Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
Amortization: F.1 75,816 75,816 75,816 75,816 75,816
Interest: FO.2 37,908 31,699 24,869 17,355 9,091
Total 113,724 107,515 100,685 93,171 84,907
Operating lease:
Lease expense: O.3 100,000 100,000 100,000 100,000 100,000

Total expense is higher for a finance lease in Years 1–3 but lower in Years 4 and 5. The largest
difference is classification; amortization and interest are presented separately for a finance
lease, whereas operating lease expense is an operating expense.

Statement of Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
Cash flow from operating activities (37,908) (31,699) (24,869) (17,355) (9,091)
Cash flow from financing activities (62,902) (68,301) (75,131) (82,645) (90,909)
Total (100,000) (100,000) (100,000) (100,000) (100,000)
Operating lease:
Cash flows from operating activities (100,000) (100,000) (100,000) (100,000) (100,000)

The difference on the statement of cash flows is only in classification, because in both cases the
total cash outflow is equal to the lease payment.

2. How would the classification, all else equal, affect EBITDA margin, total asset turnover, and cash
flow per share?

Hide Solution

Solution:

The following table shows how the classification affects the indicated financial ratios.

Impact of Using an Operating Lease Instead of a

Ratio Formula Finance Lease

EBITDA EBITDA Lower: Lease expense is classified as an operating

margin Total revenues expense rather than interest and amortization.
Asset Total revenues Lower: Total assets are higher under an operating lease
turnover Total assets because the ROU asset is amortized at a slower pace in
Years 1–3.
Cash Cash flow from operations Lower: Cash flow from operations is lower because the
flow per Shares outstanding entire lease payment is included in operating activities
share versus solely interest expense for a finance lease.

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 recognize finance leases as either “sales-type” or “direct financing,” the
distinction is immaterial from an analyst’s perspective.

At finance lease inception, the lessor recognizes a lease receivable asset equal to the present value of
future lease payments and de-recognizes the leased asset, simultaneously recognizing any difference as a
gain or loss. The discount rate used in the present value calculation is the rate implicit in the lease.

The lease receivable is subsequently reduced by each lease payment using the effective interest method.
Each lease payment is composed of interest income, which is the product of the lease receivable and the
discount rate, and principal proceeds, which equals the difference between the interest income and cash
receipt.

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 recognizes lease revenue on a straight-line
basis. Interest revenue is not recognized 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 recognize the leased asset at cost net of
accumulated depreciation.
Lease revenue is recognized on a straight-line basis on the income statement. Depreciation expense
continues to be recognized.
The entire cash receipt is reported under operating activities on the statement of cash flows. This is the
same as a finance lease.

EXAMPLE 4

Lessor Accounting
Let’s examine Proton’s machine lease from Example 2 and Example 3 from the perspective of the
lessor. Assume that the carrying value of the asset immediately prior to the lease is EUR350,000,
accumulated depreciation is zero, and the lessor elects to depreciate it on a straight-line basis over five
years.

1. How are the lessor’s financial statements affected by the classification of the lease as a finance or
operating lease?

Hide Solution

Solution:

The difference on the balance sheet is material, because a finance lease requires the lessor to
de-recognize the asset and recognize a lease receivable, whereas an operating lease lessor
continues to recognize the asset and depreciate it over its useful life. In this case, where the
present value of the lease payments is well above the carrying value of the asset, the finance
lease classification results in a significant increase in assets.

Balance Sheet Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
Lease receivable, net 316,987 248,685 173,554 90,909 0
Operating lease:
Property, plant, and equipment, net 280,000 210,000 140,000 70,000 0

The difference on the income statement is also material, because a finance lease lessor
recognizes interest revenue under the effective interest method whereas the operating lease
lessor recognizes straight-line lease revenue.

Income Statement Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
Interest revenue 37,908 31,699 24,869 17,355 9,091 Rate Your Confidence
Operating lease:
High
Lease revenue 100,000 100,000 100,000 100,000 100,000

Medium
The statement of cash flows, however, is no different for the lessor under a finance or operating
lease: The entire cash inflow from the lease payment is recognized under operating activities. Low

Statement of Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 Continue !

Finance lease:
Cash flows from operating activities 100,000 100,000 100,000 100,000 100,000 Category

Operating lease: Topics in Long-Term Liabilities

and Equity
Cash flows from operating activities 100,000 100,000 100,000 100,000 100,000

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Discussion

In the example 2, answer of the second question, how can calculate the amortization expense based on straight line method ?
VA

Created a month ago by Vishwa Ajaydeepsinh Gohil 2 replies | Last Activity: 19 days ago
Hide All replies Reply to this Comment

ZT As it's a straight line, I think you need to divide the present value by the five-year lease period. That is 379 079/5 =75 816

Ziyanda Takhona Dlamini replied 19 days ago

AS Its just ROU/5.

Arlinda Shkabari replied 19 days ago

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