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:

  1. If the lessee becomes the owner of the leased asset at the end of the lease
  2. 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
  3. If the term of the lease is 75% or more of the leased asset’s useful life
  4. 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.

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

Lease accounting, lease period extended after year 1 – Journal entries Details for lease accounting for lease extension Let us assume the following details for lease accounting: Lease start date: 1-Apr-2019 Lease end date: 31-Mar-2024 Lease payments: Rs. 2,75,000 Payment frequency: Annual – payable at the end Incremental borrowing rate: 9% Lease extension on 1-4-2020: Lease Modification effective date: 1-Apr-2020 Lease end date extended up to: 31-Mar-2026 All other terms remain the same When the lease is modified without any increase in the scope of the lease then lease liability and the right-of-use are recomputed on the effective date of such modification. This would result in amortising an additional amount and the …
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Lease accounting, interest-free deposit lease period extended after year 1

Lease accounting, interest-free deposit lease period extended after year 1 Details for lease accounting for lease extension Let us assume the following details for lease accounting: Lease start date: 1-Apr-2019 Lease end date: 31-Mar-2024 Lease payments: Rs. 2,75,000 Lease Deposit: Rs. 3,00,000 Payment frequency: Annual – payable at the end Incremental borrowing rate: 9% Lease extension on 1-4-2020: Lease Modification effective date: 1-Apr-2020 Lease end date extended up to: 31-Mar-2026 All other terms remain the same When the lease is modified without any increase in the scope of the lease then lease liability and the right-of-use are recomputed on the effective date of such modification. This would result in amortising an additional …
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Lease accounting Journal Entries for Modification

Lease accounting Journal entries for Modification Details for lease accounting with modification Let us assume the following details for lease accounting: Lease start date: 1-Apr-2019 Lease end date: 31-Mar-2024 Lease payments: Rs. 2,75,000 Lease Deposit: Rs. 3,00,000 Payment frequency: Annual – payable at the end Incremental borrowing rate: 9% Lease modification: Lease Modification effective date: 1-Apr-2020 Lease payments: Rs. 3,25,000 When the lease is modified without any increase in the scope of the lease then lease liability and the right-of-use are recomputed on the effective date of such modification. This would result in amortising an additional amount and the finance charges based on the revised lease liability should be recomputed. Right-of-use Recognition …
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Lease accounting with an interest-free deposit

Lease accounting with an interest-free deposit Details for lease accounting Let us assume the following details for lease accounting: Lease start date: 1-Apr-2019 Lease end date: 31-Mar-2024 Lease payments: Rs. 2,75,000 Lease Deposit: Rs. 3,00,000 Payment frequency: Annual – payable at the end Incremental borrowing rate: 9% Right-of-use Recognition of Lease liability Amortisation of Right-of-use Finance cost Interest free deposit Imputed interest income Amortisation of Right-of-use Trial balance Profit and Loss Account Balance Sheet
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Journal entries for lease accounting

Journal entries for lease accounting Details for lease accounting Let us assume the following details for lease accounting: Lease start date: 1-Apr-2019 Lease end date: 31-Mar-2024 Lease payments: Rs. 2,75,000 Payment frequency: Annual – payable at the end Incremental borrowing rate: 9%   Right-of-use   Recognition of Lease liability Amortisation of Right-of-use Finance cost Trial balance Profit & Loss Account Balance Sheet
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Steps in lease accounting

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Lease Accounting as per IFRS 16 vs. AS 19

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Lease modifications

Lease modifications What is meant by lease modification? A lease modification is a change in the scope of a lease, or the consideration for a lease, that was not part of its original terms and conditions. Examples of lease modifications are as follows: increasing the scope of the lease by adding the right to use additional underlying assetsdecreasing the scope of the lease by removing the right to use of some underlying assetsincreasing the scope of the lease by extending the contractual lease termchanging the consideration in the lease by increasing or decreasing the lease payments Changes that result from renegotiations and changes …
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Presentation & Disclosure – lease accounting standard

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How to compute right-to-use asset

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