Accounting Treatment of Lease

Financing and Implication for

Financial Statement Analysis
Lease Financing
● A lease is a contract between the owner of an
asset—the lessor—and another party seeking use of the
assets—the lessee. Through the lease, the lessor grants
the right to use the asset to the lessee
 Advantages of Lease
● Leases can provide less costly financing, usually require little, if
any, down payment, and are often at fixed interest rates.
● The negotiated lease contract may contain less restrictive provisions
than other forms of borrowing.
● A lease can also reduce the risks of obsolescence, residual value, and
disposition to the lessee because the lessee does not own the asset.
● The lessor may be better positioned to manage servicing the asset
and to take advantage of tax benefits of ownership.
● While providing a form of financing, certain types of leases are not
reported as debt on the balance sheet. The items leased under these
types of leases also do not appear as assets on the balance sheet.
Therefore, no interest expense or depreciation expense is included in
the income statement. Additionally, in some countries such as the
United States, financial reporting standards may differ from
reporting under tax regulations; thus, in some cases, a company may
own an asset for tax purposes (and thus obtain deductions for
depreciation expense for tax purposes) while not reflecting the
ownership in its financial statements.
Advantages of Lease
● In some cases, a company may own an asset for tax
purposes (and thus obtain deductions for depreciation
expense for tax purposes) while not reflecting the
ownership in its financial statements. A lease that is
structured to provide a company with a lease that is
structured to provide a company with the tax benefits
of ownership while not requiring the asset to be
reflected on the company’s financial statements is
known as a synthetic lease.
Finance versus Operating Leases
● Under IFRS, if substantially all the risks and rewards
incidental to ownership are transferred to the lessee,
the lease is classified as a finance lease and the lessee
reports a leased asset and a lease obligation on the
balance sheet. Otherwise, the lease is reported as an
operating lease
Classifying Leases as Capital or Operating

● Under US GAAP a lease is a capital lease of any of the

following is true:
1. The lease transfers ownership of the property to the lessee
at the end of the lease term
2. The lease contains a bargain purchase option
3. The lease term is equal to 75% or more of the estimated
economic life of the leased property (not applicable to land
or when the lease terms begins within the final 25% or the
economic life of the asset)
4. The PV of the minimum lease payments (MLPs) equals or
exceeds 90% of the fair value of leased property to lessor.
Otherwise the lease is classified as an operating lease
Reporting and disclosure considerations
for lessees

● For operating leases, lease payments are reported as

rent expenses when they become due and no assets or
liability is shown on the balance sheet for future
amounts to be paid. Future minimum lease payments
(MPL’s) are disclosed.
● For capital leases, present value of future lease
payments is shown as an asset and liability on the
balance sheet and payments are shown as interest
expense and principal repayment. The leased asset is
depreciated.
Accounting Treatment of Operating Vs
Finance Lease
Example Lease beginning December 31, 20X0 Annual
MLPs of $ 10,000 made at the end of each year for four
years Discount rate 10%
Operating lease
No entry is made at the inception of the lease Over the
life of the lease, only the annual rental expense of $
10,000 will be charged to income and CFO
Capital Lease
At the inception of the lease, an assets and liability equal
to the PV of the lease payments, $31,700, is recognized
Accounting Treatment of Operating Vs
Finance Lease
Accounting Treatment of Operating Vs. Finance
Lease

Lease capitalization increases assets balances, resulting in lower asset turnover and
ROA.
Leverage ratios: As lease obligations are not recognized for operating leases, leverage
ratios are understated. Lease capitalization adds both current and non-current liabilities
to debt, resulting in a corresponding decrease in working capital and increase in the
debt-to-equity ratio
Accounting Treatment of Operating Vs. Finance
Lease
Lease Accounting for Lessor

● Lessors that report under US GAAP determine whether

a lease is a finance (also called “capital lease”) or
operating lease using the same four criteria as a lessee,
plus additional revenue recognition criteria. If a lessor
enters into an operating lease, the lessor records any
lease revenue when earned. The lessor also continues
to report the leased asset on the balance sheet and the
asset’s associated depreciation expense on the income
statement.
 Lease Accounting for Lessor

● US GAAP make a further distinction in defining two types of

non-operating
leases:
(1) direct financing leases, and
(2) (2) sales-type
leases from the lessor’s perspective. A direct financing lease
results when the present value of lease payments (and thus the
amount recorded as a lease receivable) equals the carrying
amount of the leased asset. Because there is no “profit” on the
asset itself, the lessor is essentially providing financing to the
lessee, and the revenues earned by the lessor are financing in
nature (i.e., interest revenue). If, however, the present value of
lease payments (and thus the amount recorded as a lease
receivable) exceeds the carrying value of the leased asset, the
lease is treated as a sale.
 Financial Statement Impact Of A Sales Type
Lease For Lessor
● Assume a (hypothetical) company, Selnow Inc., owns a
piece of machinery and enters into an agreement to lease the
machinery on 1 January Year 1. In the lease contract, the
company requires four annual payments of €28,679 starting
on 1 January Year 1. The present value of the lease
payments (using a 10 percent discount rate) is €100,000,
and the fair value of the equipment is €90,000. The useful
life of the machinery is four years and its salvage value is
zero.
1. Is the lease a direct financing or sales-typelease?
2. What is Selnow’s income related to the lease in Year
1? In Year 2? Ignore taxes.
 Exercise:
● Financial Statement Impact of a Finance versus Operating Lease
for the Lessee Assume two similar (hypothetical) companies,
CAPBS Inc. and OPIS Inc., enter into similar lease agreements
for a piece of machinery on 1 January Year 1. The leases require
four annual payments of €28,679 starting on 1 January Year 1.
The useful life of the machine is four years and its salvage value
is zero. CAPBS accounts for the lease as a finance lease and uses
straight- line depreciation, while OPIS has determined the lease is
an operating lease. For simplicity, this example assumes that the
accounting rules governing these hypothetical companies do not
mandate either type of lease. The present value of lease payments
and fair value of the equipment is €100,000. (A reminder relevant
for present value calculations: Lease payments are made at the
beginning of each period.) At the beginning of Year 1, before
entering into the lease agreements, both companies reported
liabilities of €100,000 and equity of €200,000. Each year the
companies receive total revenues of €50,000, and all revenues are
cash. Assume the companies have a tax rate of 30 percent, and
use the same accounting for financial and tax purposes. Both
companies’ discount rate is 10 percent. In order to focus only on
the differences in the type of lease, assume neither company
incurs expenses other than those associated with the lease, and
neither invests excess cash.
● 1 Which company reports higher expenses/net income
in Year 1? Over the four years?
● 2 Which company reports higher total cash flow over
the four years? Cash flow from operations?
● 3 Based on return on equity (ROE), how do the two
companies’ profitability measures compare?
● 4 Based on the ratio of debt- to- equity, how do the
two companies’ solvency positions compare?