What is the difference between operating lease and finance lease?

What is the difference between operating lease and finance lease?

An operating lease and a finance lease are two types of leasing arrangements that companies can use to acquire assets such as equipment, vehicles, or buildings.

An operating lease is a short-term lease in which the lessor (the owner of the asset) rents the asset to the lessee (the user of the asset) for a specific period of time, usually less than the useful life of the asset. At the end of the lease term, the lessee returns the asset to the lessor. The lessor typically retains ownership of the asset and is responsible for maintaining and insuring it. An operating lease is often used for assets that have a short useful life or are rapidly depreciating.

A finance lease, on the other hand, is a long-term lease in which the lessee agrees to make payments to the lessor over the term of the lease, which is typically the entire useful life of the asset. At the end of the lease term, the lessee may have the option to purchase the asset at a predetermined price, return the asset to the lessor, or continue to lease the asset for a reduced rental amount. Unlike an operating lease, the lessee assumes most of the risks and benefits of ownership, including maintenance, insurance, and any residual value of the asset.

The key difference between the two types of leases is the extent to which the lessee assumes the risks and benefits of ownership. In an operating lease, the lessor retains ownership and most of the risks and benefits of ownership, while in a finance lease, the lessee assumes ownership-like risks and benefits.

What is operating lease as per US GAAP?

under the US Generally Accepted Accounting Principles (GAAP), an operating lease is accounted for as a rental agreement, and the leased asset is not recorded on the lessee’s balance sheet. Instead, the lessee records the lease payments as operating expenses on its income statement.

The key criteria for determining if a lease is an operating lease under US GAAP include:

The lease term is significantly shorter than the economic life of the leased asset.

The present value of the lease payments over the lease term is significantly less than the fair value of the leased asset.

The leased asset is of a specialized nature such that it has little or no alternative use to the lessor at the end of the lease term.

The lessor assumes substantially all of the risks and rewards of ownership of the leased asset during the lease term.

If the lease meets these criteria and is classified as an operating lease, the lessee will record the lease payments as a rental expense on its income statement, and the lessor will record the lease payments as rental revenue on its income statement. The leased asset will not be recorded on the lessee’s balance sheet, and the lessor will continue to own the asset.

What is operating lease as per IFRS 16?

under the International Financial Reporting Standards (IFRS) 16, an operating lease is accounted for differently than it was under the previous standard (IAS 17).

Under IFRS 16, a lessee is required to recognize a right-of-use asset and a lease liability for all leases with a lease term of more than 12 months, unless the underlying asset is of low value. The right-of-use asset represents the lessee’s right to use the leased asset for the lease term, while the lease liability represents the lessee’s obligation to make lease payments over the lease term.

The key criteria for determining if a lease is an operating lease under IFRS 16 include:

The lease term is for a significant part of the economic life of the leased asset.

The lessee has the right to use the leased asset.

The lessee has the ability to direct the use of the leased asset.

The lessee receives substantially all of the economic benefits from the use of the leased asset.

If the lease meets these criteria and is classified as an operating lease, the lessee will recognize the right-of-use asset and lease liability on its balance sheet. The lease liability will be initially measured at the present value of the lease payments over the lease term, and the right-of-use asset will be initially measured at the lease liability amount plus any initial direct costs incurred by the lessee.

The lessee will then recognize lease expense in its income statement, which will be composed of depreciation of the right-of-use asset and interest on the lease liability. The depreciation will be recognized over the lease term, and the interest will be recognized using the effective interest method.

It is important to note that IFRS 16 has significantly changed the accounting treatment for operating leases and has eliminated the distinction between operating and finance leases for lessees, with all leases being recognized on the balance sheet.

What is finance lease as per US GAAP?

Under the US Generally Accepted Accounting Principles (GAAP), a finance lease is accounted for as if the lessee has purchased the leased asset and obtained financing to pay for it.

The key criteria for determining if a lease is a finance lease under US GAAP include:

The lease term is for a significant part of the economic life of the leased asset.

The present value of the lease payments over the lease term is substantially all of the fair value of the leased asset.

The leased asset is expected to have a useful life beyond the lease term.

The lessee has the option to purchase the leased asset at a bargain price at the end of the lease term.

The ownership of the leased asset is expected to transfer to the lessee at the end of the lease term.

If the lease meets these criteria and is classified as a finance lease, the lessee will recognize the leased asset and lease liability on its balance sheet. The leased asset will be recorded at the present value of the lease payments, and the lease liability will be recorded at the same amount.

The lessee will then recognize depreciation expense on the leased asset over its useful life and interest expense on the lease liability using the effective interest method. The interest expense will be recognized based on the interest rate implicit in the lease or, if that rate cannot be readily determined, the lessee’s incremental borrowing rate.

In addition, the leased asset will be subject to impairment testing and may be subject to lease modifications and sale-leaseback accounting treatment.

It is important to note that the accounting treatment for finance leases can be complex and may require significant judgment and estimation. Lessees should carefully consider the terms of their leases and seek professional guidance if necessary to ensure compliance with US GAAP.

What is finance lease as per IFRS 16?

Under the International Financial Reporting Standards (IFRS) 16, a finance lease is accounted for in a similar way as it was under the previous standard (IAS 17).

Under IFRS 16, a lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset to the lessee. This means that the lessee effectively assumes ownership of the leased asset for the duration of the lease term.

The key criteria for determining if a lease is a finance lease under IFRS 16 include:

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

The lease grants the lessee an option to purchase the underlying asset, and it is reasonably certain that the option will be exercised.

The lease term covers a major part of the economic life of the underlying asset.

The present value of the lease payments, together with any guaranteed residual value, amounts to substantially all of the fair value of the underlying asset.

The underlying asset is of a specialized nature such that it is unlikely that the lessor would be able to lease the asset to another party at the end of the lease term.

If the lease meets these criteria and is classified as a finance lease, the lessee will recognize the leased asset and lease liability on its balance sheet. The leased asset will be recorded at the present value of the lease payments, and the lease liability will be recorded at the same amount.

The lessee will then recognize depreciation expense on the leased asset over its useful life and interest expense on the lease liability using the effective interest method. The interest expense will be recognized based on the interest rate implicit in the lease or, if that rate cannot be readily determined, the lessee’s incremental borrowing rate.

It is important to note that IFRS 16 has eliminated the distinction between finance and operating leases for lessors, with all leases being accounted for using a single model. However, the accounting treatment for finance leases under IFRS 16 is similar to the treatment under the previous standard (IAS 17).

Ind AS Accounting Standards

Lease accounting, lease period extended after year 1 – Journal entries

Lease accounting, interest-free deposit lease period extended after year 1

Lease accounting Journal Entries for Modification

Lease accounting with an interest-free deposit

Journal entries for lease accounting

Steps in lease accounting

Operating lease vs financing lease

Lease Accounting as per IFRS 16 vs. AS 19

Lease modifications

How to compute right-to-use asset

How to determine the lease term as per the standard

How to separate the components of a lease contract

How to identify a lease contract as per the lease accounting standard

Lease Accounting as per Ind AS 116

Presentation & Disclosure – lease accounting standard

What is the new lease accounting standard

Lease Accounting as per IFRS 16

Extracts from Annual reports – Lease Accounting

Exemptions that can be availed in lease accounting

Lease Accounting as per IFRS 16 vs. IAS 17

Objective & Scope of lease accounting standard