Leases: finance vs operating and lessee accounting (IFRS vs US GAAP)

What counts as a lease, and why lease at all?

A lease is a contract that gives one party the right to use a specific asset for a period in exchange for payments. The user is the lessee . The owner is the lessor .

A contract is a lease only if it names an identified asset, gives the customer substantially all of the economic benefit from using it, and lets the customer, not the supplier, direct how it is used. Renting a named floor of an office building that you fit out and use as you choose is a lease. Buying cloud storage that the provider serves from whichever of its servers it likes is a service, not a lease: no specific asset is identified and you do not direct its use.

Why would a company lease rather than buy? It needs little cash up front. Because the lessor can repossess the asset, the implicit financing cost is usually lower than an unsecured loan. And the lessee shifts some ownership risk, such as obsolescence. For the lessor, leasing earns interest income and widens its market to customers who would rather spread the cost over time.

How is a lease classified as finance or operating?

A lease is a finance lease when it looks like a purchase financed by the lessor. Meet any one of five tests and it is a finance lease ; meet none and it is an operating lease . These five classification criteria are identical under IFRS and US GAAP and are applied the same way by lessees and lessors.

Memorize

1. Ownership of the asset transfers to the lessee by the end of the term.
2. The lessee has a purchase option and is reasonably certain to exercise it.
3. The lease term covers a major part of the asset’s economic life.
4. The present value of the lease payments equals or exceeds substantially all of the asset’s fair value.
5. The asset is so specialized that it has no alternative use to the lessor.

Leaseright to use an identified asset for a period, in exchange for payments

• Finance lease Memorize resembles a purchase: any one test is enough
  • Ownership transfers by the end of the term
  • Purchase option reasonably certain to be exercised
  • Major part of economic life the term
  • PV of payments at least substantially all of fair value
  • No alternative use to the lessor
• Operating lease Memorize resembles a rental: none of the five tests met

Exam tip Read down the five and stop at the first yes. Test 4 is the one the exam hides in numbers: divide the PV of payments by fair value.

Go deeper Where do the numbers behind 'major part' and 'substantially all' come from?

IFRS gives no percentages. US GAAP implementation guidance commonly uses 75% of the economic life and 90% of fair value as reference points, but the curriculum and the exam do not rely on them. If a question gives you a case where one test is clearly met (a 98% present value, say), classify it as finance. If every test is clearly missed, it is operating.

When can a lessee skip lease accounting?

A lessee may expense payments straight-line, with nothing on the balance sheet, for two kinds of lease. The short-term lease exemption covers terms of 12 months or less under both IFRS and US GAAP. The low-value asset exemption covers items worth about USD 5,000 or less when new, such as laptops and small office equipment, and exists only under IFRS. Lessors get neither exemption.

How does a lessee record a lease?

On day one the lessee records a right-of-use asset and a lease liability , both equal to the present value of the lease payments. The discount rate is the rate implicit in the lease, or the lessee’s estimated secured borrowing rate if the implicit rate is unknown.

Use it

$$L_0 = P \times \frac{1 - (1+r)^{-N}}{r}$$

After that the liability runs like an amortizing loan. Each year interest accrues on the opening balance, and the rest of the payment repays principal.

$$I_t = r \times L_{t-1}$$

How the ROU asset falls, and what appears on the income statement, depends on the model.

IFRS: one model for every lease

The single lessee model treats every lease like a finance lease. The ROU asset is depreciated, usually straight-line over the lease term, and interest is charged on the liability. The two are reported separately: depreciation with other depreciation, interest with finance costs.

$$E_1 = \frac{ROU_0}{N} + r \times L_0$$

Interest is largest at the start, so total expense is front-loaded: higher than the payment early, lower than it late.

US GAAP: two models

A finance lease is accounted for exactly as under IFRS. An operating lease also gets an ROU asset and liability, but the income statement shows a single straight-line lease cost , part of operating expenses. Interest and amortization are not shown separately and do not join other interest or amortization lines. The ROU asset is reduced by the cost minus the interest, so it always equals the liability.

$$E_{op} = \frac{\text{total lease payments}}{N}$$

Lessee accounting

• IFRS: single lessee model Memorize every lease treated like a finance lease
  • Balance sheet ROU asset and lease liability
  • Income statement depreciation plus interest
  • Cash flow principal financing; interest operating or financing
• US GAAP: two models Memorize
  • Finance lease same as IFRS, interest in operating cash flow (CFO)
  • Operating lease one straight-line cost, all in CFO
• Exemptions Use it expense straight-line, nothing on the balance sheet
  • 12 months or less IFRS and US GAAP
  • Low-value asset IFRS only

Questions ask for the liability, the payment, the interest or the year-1 expense, depending on what the vignette gives you. It is the same relationship each time.

How do the cash flow statement and the ratios differ?

Total cash paid is the same in every model. What changes is where it is shown.

	IFRS (all leases)	US GAAP finance	US GAAP operating
Principal portion	financing	financing	operating
Interest portion	operating or financing, by policy	operating	operating
Operating cash flow	higher (equal to US GAAP finance if interest is in operating)	higher	lowest: the whole payment
Earnings before interest, taxes, depreciation and amortization (EBITDA)	higher: depreciation and interest sit below it	higher	lower: the cost is an operating expense
Total assets in early years	lower	lower	higher: ROU asset equals the liability

For Pelham in year 1 under IFRS, the 39,605 of principal is a financing outflow, in cash flow from financing activities (CFF), and the 10,395 of interest is operating (or financing). Under the US GAAP operating model the whole 50,000 is operating.

Because the liability is the same in every model, debt ratios look alike. The margin on earnings before interest, taxes, depreciation and amortization (EBITDA), operating cash flow and asset turnover are what move: they are better under the finance-style models and worse under the US GAAP operating model, for the same lease.

Use it

What do lessees disclose?

The notes tell you what the balance sheet cannot. The lessee disclosures include the carrying amount of ROU assets by class of asset, depreciation and interest on leases, additions to ROU assets, total cash outflow for leases, the nature of the leasing activity, any covenants or restrictions, and sale-and-leaseback transactions. The weighted average discount rate and remaining term are also given.

The most useful table is the maturity analysis of lease liabilities: undiscounted payments due in each of the next years and a total for the later years, with the imputed interest taken off to reach the liability. An analyst uses it to see when cash leaves and to treat leases as debt-like in credit analysis. Some companies report ROU assets and lease liabilities inside “other assets” or “other liabilities” rather than separate lines.

Go deeper Why the discount rate matters, and what the old rules did

A higher discount rate gives a smaller liability for the same payments, so two companies with identical leases can report different liabilities. Watch the disclosed rate. Variable payments tied to sales or usage, and extension options the lessee is not reasonably certain to use, are generally left out of the measurement and show up in the notes. Before 2019, operating leases were off the balance sheet under both systems, and analysts capitalized them by hand. Those adjustments are now mostly unnecessary, but older data and older textbooks still show the old picture.