The accounting treatment of an operating lease versus a finance lease is an interesting topic since more and more companies choose to lease their equipment instead of buying it nowadays. Accounting Standards (IAS 17 and FAS 13) recognize two different types of leases. Operating Leases and Finance Leases or as they commonly called capital leases.
Finance Lease Criteria
Both the International Accounting Standards and the Local GAAP (US or UK) do not provide a clear and concise definition for finance leases. Instead, they use a set of criteria or rules that guide users and help us distinguish what should be recognized as an finance or as an operating lease.
Specifically, the criteria that are used are the following:
- If the leasing period is the same or approximately the same as the remaining useful life of the asset, then it is a finance lease.
- If the present value of the payments that will be made are the same as the fair value of the asset then it is a finance lease.
- If the lease allow the lessee to purchase the asset at a price that is lower than the fair value of the asset, then it is a finance lease.
- Finally, if the ownership of the asset will be transferred to the lessee when the lease ends, then it is a finance lease.
From above criteria, it’s obvious that using the substance over form, the accounting standards require that the assets leased should be treated based on the economic reality rather than based on the current legal status.
In other words, if you expect that the leased asset will be transferred to your company or will be acquired by your company for a price that is significantly lower than the market value, then it should be recognized as a finance lease. The accounting treatment of the finance leases is significantly different from the accounting treatment of an operating lease since operating leases are effectively kept off balance sheet while finance leases are recognized as a normal asset owned by the company.
Finance Lease Example
For example, Company XYZ signs a lease for a piece of machinery which says that:
- The term of the lease will be 5 years.
- The present value of the payments that will be made will be $400,000
Let’s say that the remaining useful life of the asset is estimated to be 62 months or 5 years and 2 months and the current market price is $410,000. Therefore, based on the above criteria, the lease is a finance lease since the present value of the lease payments is basically the same as the fair value of the asset and the lease term is the more or less the same as the useful life of the asset.
Operating Lease Criteria
In line with the finance leases, there is no definition for an operating lease. Instead, the accounting standards say that if a lease is not a finance lease, then it has to be an operating lease.
Operating Lease Example
As an example, Company A leases a printer for 1 year and the monthly payments are agreed to be $100. Similar printers are expected to last for 3 years and their price is around $300. Therefore, since the asset will have another 67% of its useful life remaining when the lease is over and the payments that will be made constitute a portion of the fair value of the asset, then the lease is an operating lease and should be treated as such.
Advantages of Finance Leases
The accounting standards try to avoid having companies selling and leasing back assets while keeping them off balance sheet. However, leasing an asset (even with a finance lease) can have significant benefits.
- A company can avoid spending large sums for capital assets. The leasing payments will be paid on a monthly, quarterly or annual basis instead of the one off expense that will be incurred when an asset is actually acquired.
- The leasing company can be responsible (depends on the lease) for part of the maintenance or responsible to guarantee that the asset will be operating effectively for a set period of time.
- Companies can increase their asset base which is important when banking covenants are present. In other words, if the banking covenant says that the total assets should be higher than the bank loan, then finance leases can help achieve that since the cash spent is significantly lower than the asset recognized.
Advantages of Operating Leases
Operating leases also have significant advantages. For example:
- You “acquire” assets and use assets while the risks stay with the lessor.
- Your balance sheet stays the same since operating leases are kept off balance sheet.
- Return On Assets is not affected by operating leases since the fixed assets do not change.