Level 1 CFA® Exam:
Leasing
A lease is an agreement under which the lessor (that owns the asset) conveys a right to use the asset to the lessee (that uses the asset) for a specified time in exchange for periodic payments.
Leasing could be perceived as an alternative to (1) purchasing an asset using a loan or (2) renting it. It directly affects the financial ratios of both the lessee and the lessor. Because no down payment or a little down payment is required, the lessee’s liquidity is higher. In addition, leasing offers more flexible conditions of financing as compared to taking out a loan.
There are 2 major types of leases:
- a finance lease, and
- an operating lease.
A finance lease is pretty much like a loan used to finance the purchase of an asset.
An operating lease resembles a renting contract.
The difference between these 2 types of leases lies in the way the leased asset is reported in the financial statements of the lessor and the lessee.
Under both IFRS and U.S. GAAP, for a lease to be defined as a finance lease at least one of a number of conditions has to be met. These conditions are as follows:
- the ownership of the asset transfers to the lessee at the end of the lease,
- an option to buy the underlying asset is available to the lessee,
- the lease term is for the major part of the useful life of the leased asset,
- the present value of lease payments is greater or equal to the fair value of the leased asset,
- the leased asset has no alternative use to the lessor.
If the lease is not recognized as a finance lease, it is recognized as an operating lease.
Depending on the type of a lease, and whether the lessee reports under IFRS or U.S. GAAP, the lease is differently reported in the lessee’s financial statements. What follows, the lessee records different items with different values which impacts, for example, financial ratios. It’s especially important if we compare companies reporting under different standards. Hence, financial analysts should always be aware of available methods used by companies.
Under IFRS, we use the same accounting model for a finance lease and an operating lease. On the other hand, according to U.S. GAAP different models are used for both types of leases.
IFRS: Leasing from the Perspective of Lessee
Important! The rules described below are used for both finance and operating leases.
Balance sheet:
At inception, the lessee records in the balance sheet:
- lease payable liability, and
- right-of-use (ROU) asset.
The value of both the liability and ROU asset is equal to the present value of the lease payments.
(...)
Cash flow statement:
In the cash flow statement:
- principal repayment will be reported as cash outflow under cash flow from financing activities,
- interest expense will be reported under either operating or financing activities.
U.S. GAAP: Leasing from the Perspective of Lessee
Important! There are 2 accounting models under U.S. GAAP. One is used for a finance lease and the other is used in the case of an operating lease.
For the finance lease, the model used under U.S. GAAP is the same as the model described above for IFRS (with the exception that under U.S. GAAP the interest expense will be always reported under operating activities).
For an operating lease, the model is slightly different and looks as follows:
Balance sheet:
At inception, the lessee records in the balance sheet:
- lease payable liability, and
- right-of-use (ROU) asset.
The value of both the liability and ROU asset is equal to the present value of the lease payments.
As the time passes by:
- the lease payable liability gets reduced using the effective interest rate method. This means that the interest expense for each year is equal to the implicit interest rate times the value of the lease payable at the beginning of the year. And the principal repayment for each year is equal to the lease payment less the interest expense for this year.
- the amortization expense for the ROU asset is equal to the lease payment less the interest expense for a given year.
Important! As a consequence of the above, the values of the lease payable and the ROU asset are the same at the initiation of the lease agreement and also in subsequent periods.
Income statement:
The lessee will report the sum of the interest expense on the lease liability and the amortization expense related to the ROU asset as one item called lease expense. If nothing changes, the lease expense will be equal to the lease payment specified in the lease contract.
Cash flow statement:
In the cash flow statement:
The whole lease payment is reported as cash outflow under cash flow from operating activities (there are no separate items for interest expense and principal repayment).
DOMM Manufacturing, a manufacturer of plastic bags, decided to lease a piece of machinery for the sake of tax benefits. The lease term is 5 years and lease payments are USD 20,000 and are paid at the end of the year. The implicit interest rate is 5%.
How will the lease affect the company’s financial statements?
Analyze 2 scenarios:
- Scenario 1: finance lease under IFRS/U.S. GAAP
- Scenario 2: operating lease (assume: straight-line depreciation of the ROU asset) under U.S. GAAP
(...)
Under both IFRS and U.S. GAAP, leasing from the perspective of the lessor looks very similar. However, there are differences between operating and finance leases.
Finance Lease
Balance sheet:
Initially, on the balance sheet, the leased asset is derecognized and – instead – a lease receivable (a new asset) is reported. The initial value of the lease receivable is equal to the present value of the expected lease payments. If there is a difference in value between the leased asset and the lease receivable, the difference is recognized as gain or loss.
As the periodic lease payments are settled, the lease receivable gets reduced by the value of principal proceeds.
Income statement:
In the income statement, the lessor reports:
- interest revenue whose value in consecutive years is established based on the effective interest rate method.
Cash flow statement:
The entire cash inflow (interest revenue + principal proceeds = lease payment) is reported under cash flow from operating activities.
Operating Lease
Balance sheet:
The leased asset stays in the lessor’s balance sheet and it is depreciated each year.
Income statement:
In the income statement, the lessor recognizes:
- lease revenue on a straight-line basis, and
- depreciation expense.
Cash flow statement:
The entire cash inflow (equal to the expected lease payment) is reported under cash flow from operating activities each year.
The lease term is 5 years, lease payments are USD 20,000 and they are paid at the end of the year. The implied interest rate is 5%. The present value of the lease payments amounts to USD 86,590 and it is equal to the carrying amount of the leased asset. How will the lease influence the company’s (lessor) balance sheet, income statement, and cash flow statement?
Analyze 2 scenarios:
- Scenario 1: finance lease
- Scenario 2: operating lease (assume: straight-line depreciation of the asset)
(...)
- A lease is an agreement under which the lessor (that owns the asset) conveys a right to use the asset to the lessee (that uses the asset) for a specified time in exchange for periodic payments.
- There are 2 major types of leases: a finance lease and an operating lease.
- A finance lease is pretty much like a loan used to finance the purchase of an asset.
- An operating lease resembles a renting contract.
- Under IFRS, for leasing from the perspective of the lessee, we use the same accounting model for a finance lease and an operating lease. According to U.S. GAAP, different models are used for both types of leases.
- Under both IFRS and U.S. GAAP, leasing from the perspective of the lessor looks very similar. However, there are differences between operating and finance leases.