Lease Accounting by Lessee and Lessor

Lease accounting is an important accounting section as it differs depending on the end user. A lessee and a lessor report and account the leases differently. A lessor is the owner of the asset and a lessee uses the leased asset by paying periodically to the lessor. The accounting and reporting of the lease in different ways has varying effects on financial statements and ratios.

Definition of Lease

A lease is a legal agreement by which the owner of a specific asset (lessor) allows a second party (lessee) to use the asset for a specific period in exchange for periodic payments to the lessor. These periodic payments are called lease rentals. An operating lease is very similar to an asset rental. It lets the lessee use the leased asset for a specific period of time, which is generally less compared to the asset’s useful life. It is mostly used to lease equipment for short terms. A finance lease is very similar to buying an asset through external finance. It allows a lessee to own an asset with the help of direct finance from the lessor. The lessee has the option to be the permanent owner of the asset at the end of the lease term.

Classification of Lease

Both IFRS and U.S.GAAP have different criteria for classifying lease as a finance or an operating lease:

  • IFRS: If the lessee is entitled to all the risks and rewards that are related to ownership, the lease is categorized as a finance lease. The lessee needs to report the lease liability and the leased asset on the balance sheet. A lease not meeting the above criterion is categorized as an operating lease.
  • S. GAAP: A lease is categorized as a finance lease if it meets even one of these following four requirements:
    • If the lessee becomes the owner of the leased asset at the end of the lease.
    • If the lease allows the lessee to purchase the same leased asset at a price which is less than the fair value of the asset in future.
    • If the term of the lease is 75% or more of the leased asset’s useful life.
    • If the present value of the lease payments is 90% or more of the fair market value of the asset.

Accounting and Reporting by Lessee

A lessee uses the leased asset and makes regular payments to the lessor. The accounting and reporting of different leases is done as following:

Accounting for Finance Lease by Lessee

The finance lease is reported by lessee as follows on different financial statements:

  • Balance Sheet: Both leased asset and lease payable (liability) is reported. The value reported is lower of the present value of the lease payments in future or the leased asset’s fair market value.
  • Income Statement: The interest expense on the lease payable is reported. It is calculated on the lease payable at the beginning using the implied interest rate in the lease. Generally, the interest rate used is lower of the borrowing rate of a lessee and the implicit rate of a lessor. If the leased asset is depreciable, then a depreciation expense is also reported as with any other asset.
  • Cash Flow Statement: Under U.S.GAAP, the interest component of the lease payment is reported as an operating cash outflow. And the principal repayment component that reduces the lease payable is reported as a financing cash outflow. Under IFRS, the interest expense can be reported either an operating cash outflow or a financing.

Accounting for Operating Lease by Lessee

The operating lease is reported by lessee as follows on different financial statements:

  • Balance Sheet: Neither an asset nor a liability is reported.
  • Income Statement: The asset’s rent is expensed which is same as the lease payment.
  • Cash Flow Statement: The complete lease payment or the rent expense is reported as operating cash outflow.

Impact of Lease Accounting on Lessee’s Financial Statements

The difference in accounting in both the leases – finance and operating impacts the various elements of the financial statements as below:

  • Assets, liabilities, net income in later years, operating income (EBIT) and cash flow from operations are higher in finance lease as compared to that in operating lease.
  • Net income in early years and cash flow from financing are lower in finance lease as compared to that in operating lease.
  • Though total income and total cash flow remain same in both the leases.

Impact of Lease Accounting on Lessee’s Financial Ratios

As with financial statements, financial ratios are also impacted by the different leases:

Accounting and Reporting by Lessor

Accounting for Finance Lease by Lessor

For the lessor, the finance lease is of two types under U.S.GAAP. If the present value of all the lease payments is same as the carrying value of the leased asset, such lease is called direct financing lease. If the present value of the lease payments is more than the carrying value of the leased asset, it is called sales type lease. Both these types of finance lease are reported by lessor as follows on different financial statements:

  • Balance Sheet: The lease receivable is reported. The value is derived from the present value of lease payments in future. Also, the assets are reduced by the book value of the leased asset.
  • Income Statement: The interest revenue is reported. It is calculated on the lease receivable at the beginning using the interest rate in the lease.
  • Cash Flow Statement: The interest component of the lease revenue is reported as an operating cash inflow and the principal component of the payment is reported as an investing cash inflow.

Accounting for Operating Lease by Lessor

The operating lease is reported by the lessor as follows on different financial statements:

  • Balance Sheet: The leased asset is reported as always.
  • Income Statement: The interest revenue is reported as well as the depreciation related to the asset is reported.
  • Cash Flow Statement: The periodic lease payment is categorized as an operating cash inflow.

Impact of Lease Accounting on Lessor’s Financial Statements

The financial statements of the lessor is impacted by the difference in both the leases in the following ways:

  • The lease revenue and the total cash flow is similar under both the leases.
  • Income in the early years is higher in finance lease than that of operating lease.
  • Income in the later years is lower in finance lease than that of operating lease.
  • The operating cash flow is lower in finance lease than operating lease.
  • The amount of taxes in early years is higher in finance lease than operating lease.

Conclusion: The accounting and reporting of a lease differ from the perspective of a lessor and a lessee. It also further differs depending on the type of lease – finance or operating. Thus, it is imperative that the lease is properly categorized and reported as it has numerous implications on financial statements and financial ratios.

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Last updated on : March 28th, 2018
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