In the last few posts we learnt about the treatment of bonds on the financial statements and amortization of bonds. From this post we will delve into the topic of leasing of assets and learn about the different forms of leases. So lets begin….
When a company does not want to outright purchase an asset it needs for its use, it can lease the asset for a finite period or as a means of purchasing the asset over a period of time.
Leasing definition – A lease is a contract wherein the lessor (owner) grants the lessee the right to use the asset for a period of time in return for periodic payments.
- Leasing requires less costly financing compared to purchasing.
- Leasing typically requires no down payment.
- Leasing can reduce the risk of obsolescence to the lessee and he does not own the asset.
- A lease may contain less restrictive provisions compared to other forms of financing.
- Certain types of leases do not appear as debt on the balance sheet. Also the assets leased under these leases do not appear on the balance sheet. Therefore, interest expense and depreciation expense are not required to be recognized on the income statement.
- In the US, a company can own an asset for tax purposes, while no ownership of the asset is reflected on the financial statements. The lease of such an asset is known as synthetic lease. This allows the lessee to deduct depreciation expense and interest expense for tax purposes, while on the financial statements it appears as a rental agreement.
Now let’s look at the different types of leases;
Types of leasing – Finance lease vs operating lease
Finance lease definition – Finance lease is the purchase of an asset by the lessee that is financed by the lessor. Therefore at inception of the lease, the lessee will add equal amounts to assets and liabilities and over the period of the lease will recognize depreciation expense on the asset and interest expense on the liability.
Operating lease definition – An operating lease on the other hand is a rental arrangement, whereby the lessor allows the lessee use of the asset for a period of time in return for periodic rental payments. The lessee only recognizes the rental payments as rental expense in the income statement.
Now lets look at each of these lease types in detail from the perspective of the lessee and the lessor.
From the lessee’s perspective
U.S. GAAP has four specific requirements that define when a lease is a finance lease. Only one of these four requirements needs to be met for a lease to be classified as a finance lease. The requirements are as follows;
- Ownership of the asset transfers to the lessee at the end of the lease period.
- The lease contains an option for the lessee to purchase the leased asset cheaply.
- The lease period covers 75% or more of the useful life of the leased asset
- The present value of the lease payments is 90% or more of the fair value of the leased asset.
A lease not meeting any of the above specific requirements is classified as an operating lease.
From the lessor’s perspective
Under U.S. GAAP, if any one of the finance lease requirements is met, the collectability of lease payments is reasonably certain and the lessor has performed substantially under the lease, the lessor must treat the lease as a finance lease or else as an operating lease.
In case of a finance lease, the lessor removes the leased asset from its balance sheet and replaces it with a lease receivable account. In case of an operating lease, the lessor recognizes rental income in the income statement and continues to carry the leased asset on its balance sheet and recognize depreciation expense against it.
That’s all in this post guys…stay posted for more on this topic of leasing…..
For solved examples please refer to the CFA Institute books or CFA study materials. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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