Financial Accounting

Introduction

Leases are a common tool used by companies as an alternative to outright purchasing an asset. Let's explore the financial accounting concepts that pertain to simple operating and finance (capital) leases from the lessee's perspective (the lessee is paying the lessor to gain access to the item being leased). By simple lease we mean one that has a fixed payment amount for a specified number of periods. Notable amendments were made in 2018 which significantly impacted the way such leases were accounted for in financial statements starting from 2019.

We'll be discussing two primary types of leases:

• Operating Lease: This is essentially a rental lease, where the lessee rents the asset.
• Finance Lease: This arrangement is akin to a purchase, with the lessee essentially becoming the owner of the asset.

Subsequently, we will explore in detail the implications of these types of leases, along with how they are accounted for from a lessee's perspective.

Why Companies Choose Leasing

When a company needs to access plant, property or equipment for revenue generation, it has several alternatives. The company can either purchase the asset outright, or opt for a lease. Each option also includes various options and considerations.

As shown in the table below, there are various factors to consider when choosing between buying or leasing. Generally, leasing requires less upfront capital and provides greater flexibility, which includes options to exit the lease. Furthermore, leasing usually has a less stringent credit requirement due to the lower initial investment and the lessor's capacity to repossess.

Comparing the Advantages and Disadvantages of Buying vs. Leasing

	Buy	Lease
Initial Investment	Higher	Lower
Credit Quality Requirement	Higher	Lower
Flexibility / Options	Limited	Greater
Option to Depreciate	Yes	No
Accounting Treatment	Accounted as Long-Term Debt	Treated as Lease Obligation

Revised Accounting Standards for Leases (2018)

Effective from December 15, 2018, the standard for lease accounting was updated. Consequently, a liability for a lease must now be included on the balance sheet. This contrasts with the old standard where certain leases were excluded from the balance sheet, considered as 'off-balance sheet' items.

Prior to 2019, rental leases were classified as operating leases and did not feature on the balance sheet. However, starting in 2019, while still considered operating leases, they must be accounted for on the balance sheet.

Ownership leases, both prior to and since 2019, have been included on the balance sheet. Nevertheless, the terminology changed in 2019: what was previously referred to as a capital lease is now known as a finance lease. The following table provides a summary of these points.

	Old Standard (< 2019)	New Standard (>= 2019)
"Rental Lease" Terminology	Operating Lease	Operating Lease
Accounting	Off-Balance Sheet	On-Balance Sheet
"Ownership Lease" Terminology	Capital Lease	Finance Lease
Accounting	On-Balance Sheet	On-Balance Sheet

How a Lease is Classified as Operating vs. Finance

Under the current accounting standards, specifically the International Financial Reporting Standards (IFRS 16) and the Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 842, leases are generally classified as either finance leases or operating leases. However, the classification criteria differ between the two standards.

Under IFRS 16, a lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of the underlying asset to the lessee. In other words, if the lease meets any one of the following criteria, it is classified as a finance lease:

1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
2. The lessee has the option to purchase the underlying asset, and it is reasonably certain that the lessee will exercise that option.
3. The lease term covers a major part of the economic life of the underlying asset. Typically, this threshold is set at 75% or more.
4. The present value of the lease payments, together with any residual value guarantees, represents substantially all the fair value of the underlying asset.

If the lease does not meet any of the above criteria, it is classified as an operating lease under IFRS 16.

On the other hand, under ASC 842, a lease is classified as a finance lease if it meets any one of the following criteria:

1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
2. The lease grants the lessee an option to purchase the underlying asset, and it is reasonably certain that the lessee will exercise that option.
3. The lease term covers a major part of the remaining economic life of the underlying asset. The threshold for this criterion is not explicitly defined in the standard.
4. The present value of the lease payments, together with any guaranteed residual value, equals or exceeds substantially all the fair value of the underlying asset.

If the lease does not meet any of the above criteria, it is classified as an operating lease under ASC 842.

Under both IFRS 16 and ASC 842, a lease is initially considered a finance lease if it meets specific criteria. If it does not meet those criteria, it is classified as an operating lease.

You can learn more about this classification in the PwC Leases Guide and ASC 842.

Finance Leases Accounting (lessee perspective)

For a simple finance lease the accounting is relatively straight forward. The basic terms of the lease will include an interest rate and payment amount per period. The following illustrates an example of a lease that has an interest rate of 5% and an annual payment of $10,000.

1. Determine Lease Value

   The first thing to do is determine the value of the lease. This is done by calculating the present value of the payment amount per period (we will assume annual payments) that the lease requires. The interest rate associated with the lease is used to calculate the present value of the lease.

   Year	Payment	Present Value
   1	$10,000	$9,524
   2	$10,000	$9,070
   3	$10,000	$8,638
   4	$10,000	$8,227
   5	$10,000	$7,835
   Total	$50,000	$42,294.77

   In the above table, we calculated the present value of each of the 5 annual payments and then summed them. So the present value of the lease is $42,294.77.

2. Create the Depreciation Table for the Lease

   The depreciation table for the lease contains the evolution of the lease liability, interest expense, principal reduction, depreciation expense and the total annual expense associated with the lease.

   Year	Beginning Lease Liability	Interest Expense	Lease Payment	Principal Reduction	Ending Lease Liability	Straight Line Depreciation	Ending Lease Asset	R/E Expense
   1	$43,295	$2,165	$10,000	$7,835	$35,460	$8,659	$34,636	$10,824
   2	$35,460	$1,773	$10,000	$8,227	$27,232	$8,659	$25,977	$10,432
   3	$27,232	$1,362	$10,000	$8,638	$18,594	$8,659	$17,318	$10,021
   4	$18,594	$930	$10,000	$9,070	$9,524	$8,659	$8,659	$9,589
   5	$9,524	$476	$10,000	$9,524	$0	$8,659	0	$9,135

   
   

   The following is an overview of the table:

   • The Beginning lease liability in the upper left corner is the present value of the lease at the start of the lease.
   • During the first year the interest expense is calculated as \(5\% \times $43,295 = $2,165\).
   • The difference of the lease payment and the interest expense is the principal reduction.
   • The ending lease liability is the beginning lease liability less the principal reduction.
   • The straight line depreciation is calculated as the beginning lease value divided by the number of periods.
   • The ending lease liability is the net carrying value of the lease asset at the end of the year (previous period lease asset value less accumulated depreciation).

3. Balance Sheet Equation Entries

   When the lease is first added onto the balance sheet, an entry is made to increment the non-cash asset account for the lease asset as well as increment the liability account for the lease liability.

   Year	Lease Asset =	Lease Liability
   1	$43,295	$43,295

   Each year a balance sheet entry is made that accounts for the lease payment (reduction of cash account), accumulated depreciation (added to contra asset account), reduction in lease liability (directly reduced from the lease liability account) and total depreciation and interest expense (retained earnings account). A single entry for each year might look like this. Each entry is using the balance sheet equation to ensure that Asset = Liabilities + Owners Equity.

   Year	Cash	- Contra Asset =	Lease Liability	+ R/E
   1	($10,000)	$8,659	($7,835)	($10,824)
   2	($10,000)	$8,659	($8,227)	($10,432)
   3	($10,000)	$8,659	($8,638)	($10,021)
   4	($10,000)	$8,659	($9,070)	($9,589)
   5	($10,000)	$8,659	($9,524)	($9,135)

   It can be seen that the accumulated depreciation added to the contra asset account is equal to the book value of the lease asset. The lease liability account has been decremented by the same value as the beginning lease liability. And the total expense assigned to retained earnings (R/E) sums to the value of the lease payments.

   At the end of the lease, the lease asset is removed from the assets and the contra asset depreciation is removed from the contra asset account.

Change in Total R/E Expense

For a finance lease, the interest expense is greater in earlier periods of the lease and the depreciation expense is constant. This results in the expense per period that hits retained earnings and is recorded on the income statement to be larger earlier in the lease and decreases during the life of the lease.

Operating Lease Accounting (lessee perspective)

The accounting principles for operating leases closely mirror those for finance leases, particularly in cases of simple leases where the lease payment remains constant over each period. The following example will go over the similarities and difference between an operating lease and the finance lease discussed above.

1. Determine Lease Value

   The method for determining the value of a simple operating lease is the same as or the financing method, so refer to that section for details.

   For this discussion, the present value of the lease is $42,294.77.

2. Create the Amortization Table for the Lease

   The amortization table for the lease contains the evolution of the lease liability, interest expense, principal reduction, amortization expense and the total annual expense associated with the lease. While the column names are the same, how the values are calculated is slightly different.

   For the Operating lease, the main difference under FASB in the US for accounting for operating leases is that expenses are held constant over each period and the necessary amortization value is calculated to make that occur. We also do not accumulate depreciation for the operating lease and instead just reduce the value of the asset directly.

   Year	Beginning Lease Liability	Interest Expense	Lease Payment	Principal Reduction	Ending Lease Liability	"Amortization"	Ending Lease Asset	R/E Expense
   1	$43,295	$2,165	$10,000	$7,835	$35,460	$7,835	$35,460	$10,000
   2	$35,460	$1,773	$10,000	$8,227	$27,232	$8,227	$27,232	$10,000
   3	$27,232	$1,362	$10,000	$8,638	$18,594	$8,638	$18,594	$10,000
   4	$18,594	$930	$10,000	$9,070	$9,524	$9,070	$9,524	$10,000
   5	$9,524	$476	$10,000	$9,524	$0	$9,524	$0	$10,000

   
   

   The following is an overview of the table:

   • The Beginning lease liability in the upper left corner is the present value of the lease at the start of the lease (same as finance lease).
   • During the first year the interest expense is calculated as \(5\% \times $43,295 = $2,165\) (same as finance lease).
   • The difference of the lease payment and the lease expense is the principal reduction (same as finance lease).
   • The ending lease liability is the beginning lease liability less the principal reduction (same as finance lease).
   • The value of amortization is calculated as lease payment less interest expense. This is the same calculation for the principal reduction. This results in the lease asset value being reduced at the same rate as the lease liability. This is different than the finance asset.
   • The ending lease liability is the net carrying value of the lease asset at the end of the year (previous lease asset value less amortization).
   • It can be seen that the R/E expense is constant over the life of the lease and is equal to the lease payment. This is different than the finance lease, where the finance lease total expense decreases over the life of the lease due to decreasing interest expense.

3. Balance Sheet Equation Entries

   When the lease is first added onto the balance sheet, an entry is made to increment the non-cash asset account for the lease asset as well as increment the liability account for the lease liability. This is the same accounting as the finance lease.

   Year	Lease Asset =	Lease Liability
   1	$43,295	$43,295

   Each year a balance sheet entry is made that accounts for the lease payment (reduction of cash account), direct reduction of the lease asset, direct reduction in lease liability and total amortization and interest expense (retained earnings account). A single entry for each year might look like this that balances entries each year e.

   Year	Cash	Lease Asset =	Lease Liability	+ R/E
   1	($10,000)	($7,835)	($7,835)	($10,000)
   2	($10,000)	($8,227)	($8,227)	($10,000)
   3	($10,000)	($8,638)	($8,638)	($10,000)
   4	($10,000)	($9,070)	($9,070)	($10,000)
   5	($10,000)	($9,524)	($9,524)	($10,000)

   The lease liability account has been decremented by the same value as the beginning lease liability to zero out the lease liability. The total expense assigned to retained earnings (R/E) sums to the value of the lease payments and the expense per period is a constant value.

Evaluating the Liability of Off-Balance Sheet Items

Understanding the Necessity of Contractual Obligations Projection

Firms bear the obligation of rendering an estimate of their contractual commitments, representing future cash flows, for the imminent five years. The scope of these obligations is vast, stretching from long-term debt repayments and finance lease commitments, to operating lease obligations, and even off-balance sheet commitments like earmarked major purchases, employee benefit obligations, and so on.

Criteria for Liability Classification

Certain items remain off the balance sheet due to their inability to satisfy the criteria necessary for classification as a liability. To be classified as a liability, the item must:

1. Impose a future economic sacrifice.
2. Stem from a transaction that has already transpired.
3. Possess a value that can be approximated with a reasonable degree of precision.

If an item fails to fulfill these conditions, it can't be recognized on the balance sheet as a liability.

The Crucial Role of Off-Balance Sheet Items Analysis

Analyzing off-balance sheet items carries significant weight when scrutinizing a company or performing comparative analysis among various companies. Frequently, it becomes imperative to adjust and incorporate these items on the balance sheet to procure a more precise understanding of the firm's financial standing, as well as to ensure an equitable comparison between companies.

Capitalizing Off-Balance Sheet Items

Capitalizing off-balance sheet items is a crucial step that can help provide a more accurate depiction of a company's financial position, as these items, even though they aren't immediately apparent on the balance sheet, can significantly impact a company's finances and performance.

Conclusion

Understanding the financial accounting for leases, both operating and finance leases, is critical for investors. Since the 2019 changes, the distinction between the two has become more nuanced, especially in how they are represented on a company's balance sheet. It is crucial for investors to be cognizant of these details to ensure accurate and insightful financial analysis.

By considering off-balance sheet items and understanding how to bring them into the balance sheet context, investors can attain a more comprehensive understanding of a company's financial position. This allows for a more fair and insightful comparison between companies, thereby facilitating better investment decisions.

The evolution of lease accounting standards serves as a reminder of the need for constant learning in the field of financial accounting. As standards continue to change and evolve, so must our understanding and methodologies for financial analysis.

As an investor, remember that the key to successful investing lies not just in understanding the numbers, but also in understanding what lies behind these numbers. The more informed you are, the better your investment decisions will be.

Legal Disclaimer