Lessor accounting: finance vs operating leases

Who is the lessor and which tests does it use?

The lessor accounting question is the mirror image of the lessee’s. The owner of the asset applies the same five finance-lease tests as the lessee (ownership transfer, a purchase option likely to be used, a term covering most of the life, a present value of at least substantially all of fair value, and no alternative use). Any one makes it a finance lease; none makes it operating.

Unlike lessees, lessors get no short-term or low-value exemption, and International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (GAAP) are substantially identical for them. The differences you studied in the last lesson are all on the lessee’s side.

How does a lessor report a finance lease?

A finance lease is a sale on credit. The lessor derecognizes the leased asset and records a lease receivable equal to the present value of the payments, discounted at the rate implicit in the lease.

Use it

$$R_0 = \sum_{t=1}^{N} \frac{P_t}{(1+r)^t}$$

If the receivable is more than the asset’s carrying amount, the lessor books the difference as selling profit on day one. This is typical for a manufacturer or dealer leasing out what it makes.

$$S = R_0 - C$$

After that, each receipt is split. Interest income accrues on the opening receivable, and the rest of the receipt reduces the receivable. A lessor whose main business is leasing, such as a bank or leasing company, reports that interest as revenue.

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

US GAAP labels finance leases for lessors as either a sales-type lease (selling profit at the start) or a direct financing lease (the lessor simply financed a purchase and earns interest only). IFRS does not use those labels and recognizes selling profit on any finance lease where it exists. For analysis the split rarely matters.

Lessorfive tests as the lessee; no exemptions

• Finance lease Memorize asset derecognized, lease receivable recognized
  • Sales-type Use it US GAAP label: selling profit at the start
  • Direct financing Know the idea US GAAP label: interest only
  • Income interest income on the receivable
• Operating lease Memorize asset kept on the balance sheet
  • Revenue straight-line lease revenue
  • Expense depreciation of the asset
• Cash flow, either type Memorize whole receipt in operating activities

How does a lessor report an operating lease?

An operating lease is a rental. The lessor keeps the asset on its balance sheet at cost less accumulated depreciation and goes on depreciating it. It reports operating lease revenue on a straight-line basis. There is no receivable, no interest income and no selling profit.

What is the difference in numbers?

Exam items give you any two of receivable, carrying amount and profit, or the interest and the rate, and ask for the third.

Exam tip Finance lease: ask “what did the lessor sell?” and expect a receivable. Operating lease: ask “who still owns it?” and expect depreciation.

What do lessors disclose?

The lessor disclosures mirror the two models. For finance leases: selling profit or loss, finance income on the net investment in the lease and income from variable payments, along with a maturity analysis of the undiscounted receipts for at least each of the first five years and a total for later years. For operating leases: lease income, property, plant and equipment subject to operating leases by class, and the same kind of maturity analysis. Lessors also explain how they manage the risk of the residual value they keep in the asset.

Go deeper Residual value and why lessors care

At the end of the term the lessor gets the asset back and must re-lease or sell it. If the asset is worth less than expected, the lessor takes the loss, not the lessee. A lessor therefore prices the expected residual value into the payments and manages it with buy-back arrangements, remarketing and maintenance terms. In a finance lease, an unguaranteed residual value is part of the lessor’s net investment, which is why analysts look at the disclosure on residual-value risk. The exam asks only that you know it is disclosed.