Lease Accounting

What is a Lease?

Leases are contracts in which the property/asset owner allows another party to use the property/asset in exchange for some consideration, usually money or other assets. The two most common types of leases in accounting are operating and finance (or capital) leases. It is worth noting, however, that under IFRS, all leases are regarded as finance-type leases. This step-by-step guide covers the basics of lease accounting according to IFRS and US GAAP.

Operating lease vs. financing lease (capital lease)

The two most common types of leases are operating leases and financing leases (also called capital leases). In order to differentiate between the two, one must consider how fully the risks and rewards associated with ownership of the asset have been transferred to the lessee from the lessor.

Recall that under IFRS, lease classification has been abandoned as a practice. Under ASPE and GAAP, a finance lease is called a capital lease. Otherwise, it is an operating lease, which is similar to a landlord and renter contract.

Whether the risks and rewards have been fully transferred can be unclear, so IFRS outlines several criteria to identify finance leases. At least one of the following conditions must be met in order to classify a lease as a financing lease:

• Ownership transfer: The ownership of the right-of-use asset transfers from the lessor to the lessee by the end of the lease period.
• Bargain purchase option: An option is given to the lessee to purchase the asset at a price lower than its fair market value at a future date (typically the end of the lease term). This option is determined at the beginning of the lease.
• Lease term: The period of the lease lasts at least 75% of the useful economic life of the asset. The lease is noncancellable during this time.
• Present value: The net present value of the minimum lease payments required under the lease exceeds substantially all (at least 90%) of the fair value of the underlying asset at the inception of the lease.
• No alternative use: The underlying asset is of a specialized nature, and it is expected to have no alternative use at the end of the lease term.

Any other type of lease is referred to as an operating lease.

Advantages of leasing

Leasing provides several benefits that can be used to attract customers:

• Asset finance: Leasing allows a company access to assets without the hefty cost often associated with the purchase of PPE.
• Protection against obsolescence: At the end of the lease term, the leased equipment can be returned to the lessor and replaced with newer equipment through a new lease agreement. This allows a company to operate using the latest machinery for maximum efficiency.
• Flexible payment terms: Payment schedules are more flexible than loan contracts.
• Tax benefit: Depreciation is a tax-deductible expense, which is recognized by both the lessor and lessee.

Disadvantages of leasing

One major disadvantage of leasing is the agency cost problem. In a lease, the lessor will transfer all rights to the lessee for a specific period of time, creating a moral hazard issue. Because the lessee who controls the asset is not the owner of the asset, the lessee may not exercise the same amount of care as if it were his/her own asset. This separation between the asset’s ownership (lessor) and control of the asset (lessee) is referred to as the agency cost of leasing. This is an important concept in lease accounting.

Lease accounting example and steps

Let’s walk through a lease accounting example. On January 1, 2022, Company XYZ signed an eight-year lease agreement for equipment. Annual payments of $28,500 are to be made at the beginning of each year. At the end of the lease, the equipment will revert to the lessor. The equipment has a useful life of eight years and has no residual value. At the time of the lease agreement, the equipment has a fair value of $166,000. An interest rate of 10.5% and straight-line depreciation are used.

Step 1: Identify the type of lease

• There is no bargain purchase option because the equipment will revert to the lessor.
• The life of the lease is eight years and the economic life of the asset is eight years. This is 100% (refer to the lease term condition above).
• In Excel, we can calculate the PV of the minimum lease payments:
  • nper = 8
  • rate = 10.5%
  • FV = 0
  • PMT = 28,500
  • type = 1 (payment is made at the beginning of the year)
  • calculate PV as =PV(10.5%,8,28500,0,1) = $164,995
  • 164,995/166,000 = 99% (refer to the present value condition above)

Therefore, this is a finance/capital lease because at least one of the finance lease criteria is met during the lease, and the risks/rewards of the asset have been fully transferred. We have determined the proper lease accounting.

Step 2: Lease amortization schedule

Year 0 is considered the current year, 2022.

Interest expense is calculated as the opening lease liability balance multiplied by the interest rate of 10.5%, and the lease liability opening balance can be calculated in one of two ways:

• =PV(10.5%,8,-28500) — the negative figure shows that this is a cash outflow
• =NPV(10.5%, E3:E10) — the lease payments shown in the table above are in the range E3:E10

The principal payment is the difference between the actual lease payment and the interest expense. The year’s closing balance is calculated as lease liability + interest – lease payment.

Step 3: Journal entries

January 1, 2022

The equipment account in the balance sheet is debited by the present value of the minimum lease payments, and the lease liability account is the difference between the value of the equipment and cash paid at the beginning of the year. In some lease agreements, the payment is due at the end of the year, so the lease liability account balance would equal the equipment account balance in this initial entry. The cash entry would not be required at this point, but at the end of the year upon payment.

December 31, 2022

Straight-line depreciation expense must be recorded for the equipment that is leased. This is based on the calculated equipment cost of $164,995, which is apportioned equally over eight years at $20,624 per year.

DR Interest Expense 15,678

CR Interest Payable 15,678

January 1, 2023

As we debit the lease liability account with the principal payment each year, its balance reduces until it reaches zero at the end of the lease term.

December 31, 2023

 Treatment under operating lease terms

January 1, 2022

December 31, 2022

January 1, 2023

December 31, 2023

In the operating lease scenario, the lease expense is constant throughout the lease term. The lease liability account is reduced annually by an amount equivalent to the finance lease’s interest expense, and lastly, the equipment account is reduced by the difference between the lease expense and the lease liability change. This last quantity is a plug to get our debits and credits equal, and these amounts will sum up to the lease liability balance over the lease term.

Additional Resources

You can read more about lease accounting on the IFRS website.

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