Financial Memos

In this tutorial, we’ll explore the difference between operating leases and finance leases, with a particular focus on the journal entries involved in both. By the end, you’ll understand how each lease type affects the financial statements and how to record the necessary entries to accurately represent them. Introduction to Leases A lease is a contractual agreement where a lessee (the party renting the asset) agrees to pay the lessor (the party owning the asset) for the use of an asset over a defined period of time. Leases fall under two primary categories: Operating leases (often referred to as "off-balance sheet" leases, though this is changing with new standards). Finance leases (also called capital leases, which lead to asset ownership being transferred, either in fact or substance). The classification determines how the lease is recorded in financial statements, especially under IFRS 16 (for international standards) and ASC 842 (for U.S. GAAP). Let’s start by defining each type of lease in more detail before we dive into the journal entries. 1. Finance Lease (Capital Lease) A finance lease is treated as though the lessee has purchased the leased asset. The substance of the transaction is a financed purchase, with the lessee recording both the asset and a liability for future lease payments on the balance sheet. Finance leases transfer the risks and rewards of ownership to the lessee. Criteria for Finance Lease: A lease is typically classified as a finance lease if it meets one or more of the following criteria: Transfer of ownership: The lease transfers ownership of the asset to the lessee at the end of the lease term. Bargain purchase option: The lessee has an option to purchase the asset at a price significantly lower than the fair market value. Lease term: The lease term covers a major part (usually 75% or more) of the economic life of the asset. Present value: The present value of lease payments amounts to substantially all (usually 90% or more) of the fair value of the leased asset. Specialized asset: The asset is so specialized that it’s only useful to the lessee and cannot be used by others without significant modifications. Initial Recognition of Finance Lease Let's look at a practical example. Example 1: Recording a Finance Lease Assume Company A enters into a finance lease agreement to lease a piece of equipment for five years. The fair value of the equipment is $100,000. The present value of the lease payments amounts to $90,000, and the company will own the asset at the end of the lease term. The journal entries for the finance lease would be as follows: Initial Lease Recognition: Journal Entry 1: Recognizing the Lease Asset and Lease Liability Debit: Right-of-Use Asset (Equipment) $90,000 Credit: Lease Liability $90,000 This entry reflects the recognition of the equipment as an asset and the corresponding liability for future lease payments. The amount recorded represents the present value of the lease payments. Subsequent Entries for Lease Payments: Each payment consists of both interest and principal repayment. Suppose the first annual payment is $20,000, with an interest portion of $5,000. Journal Entry 2: First Lease Payment Debit: Lease Liability $15,000 Debit: Interest Expense $5,000 Credit: Cash/Bank $20,000 This entry reduces the lease liability by the portion of the payment attributed to principal and records the interest expense for the financing cost of the lease. Depreciation of the Right-of-Use Asset: In a finance lease, the asset (right-of-use) is depreciated over its useful life. Assuming straight-line depreciation over five years: Journal Entry 3: Depreciation of Lease Asset Debit: Depreciation Expense $18,000 ($90,000 ÷ 5 years) Credit: Accumulated Depreciation – Right-of-Use Asset $18,000 The right-of-use asset will be depreciated over the shorter of the lease term or its useful life, depending on whether ownership transfers to the lessee at the end of the lease. Summary of Finance Lease Impact on Financial Statements: Balance Sheet: Both the asset and liability are recognized, increasing the company's total assets and liabilities. Income Statement: The interest portion of each lease payment is recorded as an expense, and the asset is depreciated over the lease term. Cash Flow Statement: Principal payments reduce the lease liability, and interest is reflected in operating activities under U.S. GAAP. 2. Operating Lease An operating lease is essentially treated like renting an asset. The lessee does not record the leased asset or liability on the balance sheet (in the past), but under IFRS 16, this has changed. Now, operating leases also require recognizing a right-of-use asset and corresponding lease liability. However, the expense recognition pattern is different from finance leases. Initial Recognition of Operating Lease In an operating lease, while the right-of-use asset and lease liability are recognized on the balance sheet, the lease expense is generally recognized on a straight-line basis over the lease term. There is no separation of interest and principal components, which differs from finance leases. Example 2: Recording an Operating Lease Assume Company B enters into an operating lease for office space for three years, with annual lease payments of $50,000. The present value of the lease payments is calculated to be $135,000. Initial Lease Recognition: Journal Entry 1: Recognizing the Lease Asset and Liability Debit: Right-of-Use Asset $135,000 Credit: Lease Liability $135,000 This is similar to the finance lease entry in terms of initial recognition. Lease Payment Entries: For operating leases, the entire lease payment is recognized as an expense. Journal Entry 2: First Lease Payment Debit: Lease Expense $50,000 Credit: Cash/Bank $50,000 The expense is recognized on a straight-line basis over the lease term. Depreciation of Right-of-Use Asset: Under an operating lease, while the right-of-use asset is recognized, the expense pattern differs. The asset is depreciated based on the straight-line lease payments. Journal Entry 3: Depreciation of Right-of-Use Asset Debit: Lease Expense $50,000 Credit: Accumulated Depreciation – Right-of-Use Asset $50,000 Summary of Operating Lease Impact on Financial Statements: Balance Sheet: The right-of-use asset and lease liability are recognized, similar to finance leases. Income Statement: Lease expense is recognized on a straight-line basis over the lease term. Cash Flow Statement: Lease payments are treated as operating cash flows. Key Differences Between Finance and Operating Lease Journal Entries AspectFinance LeaseOperating LeaseInitial RecognitionRight-of-use asset and liability recordedRight-of-use asset and liability recordedSubsequent TreatmentInterest and depreciation separatedLease expense recognized straight-lineOwnership TransferOwnership of asset typically transfersAsset ownership remains with the lessorLease PaymentsLease payments divided into principal and interestLease payments treated as expensesImpact on FinancialsBoth balance sheet and income statement affected by interest and depreciationOperating expenses directly recorded as lease expenses Conclusion In summary, while both finance and operating leases require the recognition of right-of-use assets and lease liabilities under modern accounting standards (IFRS 16, ASC 842), the treatment of subsequent journal entries significantly differs: Finance leases recognize interest and depreciation separately, treating the transaction more like a financed purchase. Operating leases record the entire lease payment as an expense on a straight-line basis over the lease term. Understanding the difference is crucial for accurate financial reporting and decision-making, particularly when analyzing a company’s financial position and its lease obligations.