In this episode of What’s New at CFI on FinPod, we discuss accounting for leases, focusing on the key differences between operating and finance leases under US GAAP and IFRS. We explain the recent changes in accounting standards and how they impact financial analysts when comparing companies using different reporting frameworks. We cover essential topics like how to treat lease liabilities and assets on the balance sheet and the implications for financial analysis and valuation.

Whether you’re dealing with finance leases, operating leases, or comparing companies across accounting standards, this discussion provides practical tips and real-world examples to help you navigate the complexities of correctly classifying leases, adjusting for different accounting treatments, and ensuring accurate financial reporting.

If you’re a financial analyst or just interested in understanding the latest insights in lease accounting, this episode is packed with insights to expand your knowledge and improve your ability to interpret financial statements.

Transcript

Asim (00:14)
Hello and welcome to the What’s New at CFI podcast. I’m Asim Khan, and I’m joined today by Scott Powell, our chief content officer and co-founder. Scott, welcome to the podcast.

Scott (00:24)
Thanks Asim. Always pleased to be here.

Asim (00:27)
Great to have you. So you’ve just published a course on accounting for leases. Could you please take us through the motivation for doing that course and what learners can expect to find there?

Scott (00:37)
Yeah.

So, our accounting courses are specifically tailored to people in finance or financial analysts. And often one of the things that has been a big pain for financial analysts in the past is dealing with operating versus finance leases. But there’s been a lot of changes recently and there’s a lot of confusion on how to, what is, what an operating lease is now compared to a finance lease under US GAAP. And if we’re comparing a company under IFRS with a US GAAP company, what do we need to adjust if any? And,

because of the recent changes, we wanted to be ahead of the curve so we could give our learners clarity around what do we mean now by an operating lease under US GAAP because it certainly is not what we used to mean when we said operating lease a few years ago.

Asim (01:27)
And so what’s the difference then?

Scott (01:31)
So the big picture, just for our listeners, is that there has been significant convergence between IFRS and US GAAP. So long story short, generally, it’s going to be less likely that you’re going to have to make any adjustments if you’re comparing a company under IFRS versus US GAAP. But there are some things to note, and I’m happy to explain some of those things on this podcast.

Asim (01:57)
Yeah, please do. I suppose we can just get a bit more fundamental and talk about the differences between a finance lease and an operating lease.

Scott (02:01)
Yeah.

Yes, so I’m going to start with the finance lease because under IFRS there’s only one treatment and that’s equivalent to what in you under US GAAP we would call a finance lease. So the key thing now is that under a finance lease and under IFRS what you’re going to do is this you’re basically going to take that lease and turn it into an asset and a liability. So we’re basically saying this lease is going to we’re going to assume it’s like we own the asset and we’ve taken debt out

to fund the asset.

Now, one of the things you always have to be mindful of is, therefore, on the balance sheet, there are two line items possibly for debt, two line items for property, plant, and equipment that we may want to combine to get a full picture of the debt of a company or the assets of a company. So you might see something on the balance sheet in terms of an asset that says right-of-use or ROU asset. That’s telling you that’s a lease that has been capitalized. So that’s the equivalent of property, plant, and equipment.

You might also see under debt something that will say debt related to right-of-use assets. There’s many synonyms and you want to treat that as interest-bearing debt. So and what you’re going to do generally with your finance lease or all leases under IFRS is you’re going to take that asset and you’re going to depreciate it like you would any other asset. Typically, most companies will use straight-line and will so we’ll take that right-of-use asset and we’ll amortize it just like we would PP&E.

And so let’s say it’s a five-year life asset. There are going to be equal chunks. If it’s $250,000 and it’s five years, every year, we’re going to depreciate $50,000 until we get to zero. And we’re always assuming an end of life that is zero. There’s no scrap value because the lease ends.

Now, on the finance side, what we’re going to be doing, and this is under under finance leases under US GAAP and also under IFRS, is we’re going to treat that as a loan. And so we’re going to typically we’re going to identify the interest rate used and that interest rate will be the discount rate that is used and that interest rate we’re going to calculate based on the opening balance of the debt. So that lease liability, which is really debt, we’ll say okay if it’s 5 % and our opening balance is 250,000 that will be our interest. And,

and then the rest will pay down of the amount because it still has to go to zero. So if we start with 250, it still has to go to zero. So we’ll calculate the interest first and then the remaining amount will be deemed a principal pay down and we’ll get to zero.

Asim (04:40)
I see. So that remaining amount is, in effect, a plug number that lets you achieve a straight line amortization down to zero of the opening balance. Is that correct? Perfect. Yeah.

Scott (04:51)
For the asset, you got it. But when you’re looking at the principal payments, that number’s typically gonna rise because of course your interest costs are higher the larger your principal amount is. And as you slowly pay down that principal, so you’ll see a different trend down for the least liability related to the right of use asset. But both, if they start at 250, they will end at zero. But you’ll see a different kind of drawdown or reduction in value.

Asim (05:20)
Okay

Scott (05:21)
Okay, but the good news is those assets are now all on the balance sheet. And the liabilities related to those assets.

Asim (05:29)
and the liabilities. And then with operating leases, the difference would be.

Scott (05:32)
Yeah, so this is the confusing thing for most people. Under US, remember IFRS we’re done. There’s just that one treatment. So that’s the good news. And there are finance leases under US GAAP and those use the same rules. US GAAP still allows for operating leases. And here’s the deal. There are five rules. And if any of these five rules apply, then what happens, and I’m just gonna pull up, I’m gonna make sure I have those five rules in front of me, just so I can talk them through. Just a second here.

Okay, so if any of these five rules apply, then it is a finance lease. Okay, it’s not and these five. So for example, if the ownership of the underlying asset transfers to the person leasing it by the end of the lease term, then it’s a finance lease.

If that person who’s renting it or leasing it has the option to purchase the underlying asset and it’s reasonably certain they’ll do so, then it’s a finance lease. If the lease term is long, so it covers the majority of the useful life of the asset, deemed to be 75 % or more, then it’s a finance lease. Also, if you do a present value or DCF calculation and you look at all those lease payments and you basically DCF it and it matches or exceeds the fair value of the asset, that’s another thing. And then, finally,

if the underlying leased asset has no alternative use at the end of the lease, then it’s a finance lease. So that’s going to cover quite a few leases, but if none of those five apply, then you actually have to de -mid an operating lease.

Now, way back when I started my career, what that meant was that you only put a rental expense on your income statement and nothing appeared on the balance sheet. But where people are confused now is operating leases now, even though technically it’s a separate category, are treated very similarly to finance leases. And that’s why we wanted to create this course, to really get rid of this confusion that’s out there amongst financial analysts.

Asim (07:33)
Okay, so what you’re saying is, previously, the operating lease wasn’t treated as a debt instrument. It was basically the company was renting some asset. They would run the rent expense through the income statement and not mention this operating lease on the balance sheet, right? Even though it was an asset and all that. And so now there’s been kind of convergence there.

Scott (07:52)
You got it.

Yeah, and we work through, because this feels so abstract, one of the things that was really important to myself and my colleague Jeff, who built this course together, is we needed to give you some concrete examples. So we go into Excel and we basically show you how to do it under US GAAP and IFRS, both ways. And what you see is it’s not that different now under US GAAP. And I’m going to sound nerdy here because I love this stuff, but it’s really detailed. So maybe it’s too detailed, but…

Asim (08:24)
Go for it.

Scott (08:25)
With the operating lease, you still have to put an asset on the balance sheet now, and you have to put a lease liability. But there’s a slightly different treatment as it relates to how you amortize the asset, not the lease liability. The lease liability is the same. But when you think about the asset, I told you, you might recall I said we’re going to amortize it based on a straight line depreciation.

Not in the case of an operating lease. The way you amortize that is basically identical to what you’re doing with your lease liability, your loan. So, we start by calculating the interest on the opening balance. Anything on the payment that’s left goes to principal paydown. And that principal pay down is the amount that we also reduce the asset.

So the way to think about it is let’s imagine that we start with an asset of 250 and a lease liability of 250. We say that there’s interest of, if there’s 50,000 of payment that has to be done in year one, of that 50,000 of payment, 10,000 is interest, 40,000 is principal paydown. So that means at the end of the year, our loan has gone from 250 minus principal pay down of 40, we get 210.

But what we do with the asset, the right of use asset under an operating lease, is start with 250 and we also deduct the principal pay down and get 210. So an operating lease, you’ll see the reduction of the asset and the lease liability match each year if you’re to look at an individual asset.

Remember with a finance lease, it’s different. They’re not going to match because we actually do at least liability with the principal paydown. But the asset itself, we amortize as though we own it. So we depreciate it like straight-line depreciation. I know that’s a minor point, but check out the course to really see the difference. My biggest message to all our learners is the good news is we used to have to do tons of adjustments when comparing companies who were reporting operating leases versus finance leases.

There has been dramatic convergence between what is an operating lease and a finance lease under US GAAP and how US GAAP compares to IFRS.

Asim (10:31)
Yes, okay, got it. And crucially as well, if you’re calculating an enterprise value, both are dead for the purposes of the dead calculation, right?

Scott (10:40)
Correct. You got it. So you want to be including that. The mistake that some new analysts make when it comes to valuation is you exclude that. Please, that is debt financing. The golden rule is, is it interest-bearing? Is there a cost to it? And yes, there’s a cost to it. So we’re going to include that.

Asim (10:58)
Great. So that course is available now, I believe. Yeah. And please check it out because I used to teach this stuff as well, and it was a major source of confusion and I’m hoping we can set things right with this course and for our learners. So Scott, thank you so much for your time and we’ll see you again on the next podcast.

Scott (11:03)
You got it. Check out the course.

See you on the next podcast.