A question that regularly comes up when considering lease finance of an asset, is how to account for the lease in your business accounts. Is it a rental cost to be charged to the P&L? Or it it an asset to be capitalised to your balance sheet?

It depends on the nature of your lease. On the face of it all leases may look the same  – you are paying a monthly fee to rent an asset that belongs to someone else. However, when you look more closely at the transaction – you will find that all leases are not  equal.

Here follows an introduction to the principles of lease accounting.

Please do take professional advice as the devil is often in the small print of your contract and the substance over form of the arrangement.

Accounting for leases

When accounting for leases , one must determine whether a lease is a short-term hire contract with most risks associated with the asset remaining with the lessor and rentals charged to profit and loss (operating lease), or whether it is a financing arrangement for the use of fixed assets (finance lease), where the accounting requirements are based on the substance of the transaction .

The lessor generally retains the right of ownership but whilst the lessee obtains use of the asset for a specific period of time in return for agreed rental payments.

Terminology

Terminology Definition
Lease A contract between a lessor and a lessee for the use of a specific asset for a specified period of time, in return for a stream of rental payments. Legal title to the asset remains with the lessor.
Lessor The entity holding the legal title to an asset that it leases to another entity.
Lessee A party who leases an asset from a lessor.
Classification

Whether a lease is classified as a finance or operating lease will depend on the substance of the transaction, rather than the legal form of the contract.

Classification Characteristics
Finance lease A lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. Finance leases are recorded on the balance sheet.
Operating lease A lease other than a finance lease (well, that’s helpful!) , which usually involves the lessee paying a rental for the hire of an asset for a period of time, normally substantially less than its useful economic life. Operating lease payments are recognised as an expense over the lease term. A lease is classified as a operating lease if it does not transfer all the risks and rewards of ownership to the lessee.
Hire purchase contract A method of buying goods where the purchaser takes immediate possession on payment of an initial installment of the price (deposit). Legal title passes to purchaser when all installments have been paid.
Sale and leaseback transaction A sale and leaseback transaction is a linked arrangement , typically involving a property, in which the owner of the asset sells that asset and then leases it back from the purchaser.

Lets explore this in more detail.


Operating versus Finance Lease – risk and reward indicators

All leases transfer some of the risks and rewards of ownership to the lessee, and the distinction between an operating lease and a finance lease is essentially one of degree, as discerned from the terms of the contract between the lessor and lessee.

Assets held under both finance leases and operating leases are not legally owned by the lessee because the rights granted relate to use, and not ownership.

The lessor generally retains the right of ownership whilst the lessee obtains use of the asset for a specific period of time in return for agreed rental payments.

Despite their similarities in form, the substance of the transaction defines the accounting treatment

So what are the indicators of a finance or an operating lease? In accounting terms, a lease is always an operating lease unless it meets at least one of the criteria of a finance lease.

 

Finance Lease Operating Lease
Accounting treatment Capitalise – this is effectively a secured loan to buy an asset Expense to P&L – this is effectively a rental agreement
Transfer of Ownership at end of term Expected to transfer to lessee at the end of the term Remains with lessor
Option to Purchase at the end of term The lessee has the option to purchase the asset at a price that is:

  1. expected to be sufficiently lower than the fair value at the date of the option exercisability, and
  2. it is reasonably certain, at the inception of the lease, that the option will be exercised
  3. If the option is not exercised, the lessee may return or rehire the asset. Secondary rentals are often at a peppercorn rate
N/a as ownership remains with the lessor.Asset might be handed back to the lessor who may then sell it or, or may remain with the lessee and hired over a secondary hire period at fair market value
Lease term For the majority, say 75%* of the of the expected economic life of the asset For a term substantially shorter than the expected economic life of the asset say < 75%*
Value of Rental Payments The total value of the rental payments will cover a  substantial say, 90%* proportion of the value of the asset. The lease terms ensure that the lessor will have recovered his investment by the end of the lease The total value of the rental payments will not cover the majority of the value of the asset. The lessor is not expecting to recover the value of his investment by the end of the lease
Cancellation Technically non-cancellable or comes with high early termination penalties The agreement can often be terminated with relatively low termination costs – sometimes as low as 30 days after 1 year in place
Responsibility for Maintenance The lessee Maintenance agreements are often built into operating leases, otherwise the lessee

* Indicative only

Accounting regulations are under review at the time of writing this article, however at the current time, operating leases are an off balance sheet arrangement and finance leases are on balance sheet.

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