Lease is the contract between the owner (lessor) and the user (lessee), where the owner conveys the property or asset to the user for some specified time in exchange for the periodic payments.
There are mainly two types of leases, the capital lease, and the operating lease.
The main advantages of a lease contract are:
a. It conserves cash.
b. This arrangement is a hedge against obsolescence for the user.
c. There are fewer restrictions than borrowing and it is, at times, cheaper also.
d. A lease transaction also has a tax advantage as well, sometimes.
1. Lessee’s Perspective
a. Under U.S. GAAP, a lease can be classified as a capital lease if any of the following conditions are satisfied:
i. if ownership is transferred to the lessee at the end of the term of the contract,
ii. if a bargain purchase option exists at the end of the lease term,
iii. if the term of the lease contract consists of more than 75% of the life of the asset, or
iv. if the discounted value of all the payments at the time of inception of the contract is greater than 90% of the fair value of the asset.
If none of these conditions are satisfied then the contract may be termed as an operating lease.
c. Under IFRS, if all the risk and reward of ownership of the asset gets transferred to the lessee the contract may be termed as a finance lease.
d. The operating lease would have the following treatments in the books of the lessee:
i. There would be no effect on the balance sheet of the firm.
ii. Leasehold rent is expensed each year in the income statement.
iii. Cash outflow for the rental payments is reflected in the cash from operations section of the cash flow statement.
e. The capital/financing lease has the following treatments in the books of the lessee:
i. Lease-related asset/liability is created at the time of inception of the lease.
ii. The value of the asset is the discounted value of all the future payments and is reflected in the balance sheet of the firm as a long-lived asset and is depreciated each year.
iii. The value of the liability is the present value of all the future payments (including principal and interest) and is reflected in the balance sheet of the firm as an obligation under capital lease. All the payments due within one year are reflected under current liability those due after one year, under non-current liability.
iv. Under the cash flow statement, the interest payment is reflected in the cash outflow from operations, and the principal payments are reflected under the cash flow from the financing section as outflows.
f. The balance sheet effect of different items under finance and the operating lease would be as follows:
Item |
Finance Lease |
Operating Lease |
Assets |
Higher |
Lower |
Current Liabilities |
Higher |
Lower |
Long Term Liabilities |
Higher |
Lower |
Cash |
Same |
Same |
g. The income statement effect of different items under finance and the operating lease would be as follows:
Item |
Finance Lease |
Operating Lease |
Operating Expense |
Lower |
Higher |
Non-Operating Expenses |
Higher |
Lower |
Earnings Before Interest and Taxes |
Higher |
Lower |
Total Expenses: |
||
Earlier Years |
Higher |
Lower |
Later Years |
Lower |
Higher |
Net Income: |
||
Earlier Years |
Lower |
Higher |
Later Years |
Higher |
Lower |
h. The cash-flow statement effect of different items under finance and the operating lease would be as follows:
Item |
Finance Lease |
Operating Lease |
Cash from Operations |
Higher |
Lower |
Cash from Financing |
Lower |
Higher |
Total Cash Flow |
Same |
Same |
i. The effect on different ratios under the finance/capital lease in comparison to the operating lease would be as follows:
Ratio |
Numerator |
Denominator |
Effect (Impact) |
Asset Turnover Ratio |
Same |
Higher |
Lower (Negative) |
Return on Asset |
Lower |
Higher |
Lower (Negative) |
Current Ratio |
Same |
Higher |
Lower (Negative) |
Debt/Equity |
Higher |
Same |
Higher (Negative) |
Debt/Asset |
Higher |
Higher |
Higher (Negative) |
Return on Equity |
Lower |
Same |
Lower (Negative) |
j. Some of the disclosures required by the lessee under GAAP are:
i. The lessee needs to disclose the lease obligation for each of the next five years for all operating and financing leases.
ii. For operating leases, the firm needs to report the effect on the books if they were the financial leases.
k. Some of the disclosures required by the lessee under IFRS are:
i. finance lease obligations as a part of the debt on the balance sheet,
ii. amount of total debt attributable to obligations under finance lease, and
iii. for both operating and finance lease:
# the future payments for the first year, and
# payment for year two up to year five aggregated and reported separately and any other payment beyond year five aggregated and reported separately.
2. Lessor’s Perspective
a. Under IFRS a lease contract should be considered as a finance lease if all risk and reward of ownership are transferred to the lessee.
b. Under GAAP, it should be considered as a finance lease if any of the four conditions mentioned previously are met by the lessee. Apart from these conditions, a lease should be considered as a finance lease if additional two conditions are also met. These additional conditions are:
i. the collectability of the lease payments are predictable, and
ii. the amount of cost still to be incurred by the lessor is most certain.
c. If a lease is an operating lease,
i. the lease revenue forms a part of revenue on the income statement,
ii. the lease assets are reflected under the non-current assets section of the balance sheet, and
iii. depreciation on leased assets is expensed on the income statement.
d. If a lease is considered as a financing lease, then:
i. the receivables, i.e. present value of all future payments are reflected as assets on the balance sheet,
ii. the present value of the principal portion is reduced from the assets on the balance sheet, and
iii. the present value of the interest portion is added to the income statement as revenue.
e. For capital leases, GAAP classifies the sales into two types (IFRS does not make any distinction); they are:
i. Sales Type Lease. According to this classification, the contract is considered as a sale that is financed by the seller itself. Under this type of transaction, a sale is recorded to set up the receivable.
ii. Direct Financing Leases. Here the lessor is considered as not involved in selling the asset, he is considered as involved in leasing the asset. Here only one transaction of recording the receivable is made.
f. The effects on different items of a financial statement under operating and financing lease are:
Item |
Finance Lease |
Operating Lease |
Total Net Income |
Same |
Same |
Net Income- Earlier Years |
Higher |
Lower |
Taxes- Earlier Years |
Higher |
Lower |
Total Cash from Operations |
Lower |
Higher |
Total Cash from Investments |
Higher |
Lower |
Total Cash Flows |
Same |
Same |