The accounting treatment of an operating lease vs a finance lease is an interesting topic. More and more companies choose to lease their equipment instead of buying it nowadays. Accounting Standards (IAS 17 and FAS 13) recognise two different types of leases. Operating leases and finance leases or as they commonly called capital leases.
Finance Lease Criteria
The International Financial Reporting Standards and GAAP do not provide a clear and concise definition for finance leases. Instead, they use a set of criteria that guide users and help us distinguish between a finance and operating lease.
Specifically, the criteria that the standards set out are:
- When 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 are the same as the fair value of the asset then it is a finance lease.
- If the lessee can purchase the asset at a price that is lower than the fair value of the asset, then it is a finance lease.
- Finally, ownership of the asset is to transfer to the lessee when the lease ends, then it is a finance lease.
From the above criteria, it’s evident that using the substance over form, the accounting standards require that when treating the agreement as an operating vs a finance lease, we consider the economic substance rather than legal status.
In other words, if you expect that the leased asset will be transferred to your company or acquired by your company for a significantly lower price than the market value, it should be recognised as a finance lease. The accounting treatment of the finance lease is substantially different from the accounting treatment of an operating lease. This difference arises because we keep operating leases off-balance sheet. In contrast, we recognise finance leases as standard assets 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 five years.
- The present value of the payments that will be made will be $400,000
Let’s say the asset’s remaining useful life is an estimated 62 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 the same as the asset’s fair value, and the lease term is more or less the same as the useful life of the lease term asset.
Operating Lease Criteria
In line with the finance leases, there is no definition for an operating lease. Instead, the accounting standards say if a lease is not a finance lease, it is an operating lease.
Operating Lease Example
For example, Company A leases a printer for one year, and the monthly payments are agreed to be $100. Similar printers typically last for three years, and their price is around $300. Therefore, since the asset will have another 67 per cent of its useful life remaining when the lease is over, and the lessee’s payments constitute a portion of the asset’s fair value, 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 are monthly, quarterly or annually instead of the one off cost of an asset purchase.
- 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 not on balance sheet.
- Operating leases do not affect return on assets as the fixed assets figure does not change.