Operating lease vs financing lease
Classification of Lease
Leases are classified as either finance lease or operating lease.
- A finance lease is like buying an asset with the finance provided by an external party. It allows a lessee to own an asset with the help of finance from the lessor. The lessee has the option to be the permanent owner of the asset at the end of the lease term, subject to certain terms.
- An operating lease is like an asset rental. It allows the lessee to use the leased asset for a specific period of time. The specified period of time usually less compared to the useful life of the asset.
Finance lease as per IFRS
As per 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 leased asset is shown as both an asset in the form of right-of-use and a corresponding liability in the balance sheet. The computation of the right-of-use is provided in this guide elsewhere.
Operating lease as per IFRS
A lease not meeting the above criterion is categorized as an operating lease.
Finance lease as per US GAAP
A lease is categorized as a finance lease if it meets any 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 for Finance Lease by Lessee
The finance lease is reported by the lessee as follows on different financial statements:
Balance Sheet: Right-of-use is shown as an asset. The lease liability is shown as a liability.
Income Statement: The interest on the lease liability is shown an expense. It is calculated on the lease payable at the beginning using the implicit interest rate in the lease.
The interest rate used for discounting purposes is the implicit rate of the lease. If it is not possible to compute the rate implicit in the lese, then the incremental borrowing rate is taken.
The amortisation of the right-of-use is shown as depreciation expense, if the leased asset is depreciable.
If there is any advance paid for the lease, then the lessee is entitled to interest income on the advance amount. Such interest receivable is shown as an income.
If the advance is interest-free, then there is no interest that is receivable on such advance. In such a case, an imputed interest is computed and shown as interest income. The Lease Advance is the adjusted to take care of the imputed interest income.
Accounting for Operating Lease by Lessee
The operating lease is reported by the lessee as follows on different financial statements:
Balance Sheet: No asset nor a liability is shown pertaining to the lease.
Income Statement: Rent is shown as an expense which is the same as the lease rentals payable.