#what is a lease?
A lease is classified as an agreement between two parties, where the lessee gains a long-term contract for the use of an asset and the lessor is assured of regular payments for a specified number of years. The two parties involved are as follows:
1. Lessor, by law is the owner of the asset.
2. Lessee, is the party that rents the asset.
1. #finance lease or Capital Lease, is a commercial arrangement among the lessor and the lessee, which is as follows:
- Lessee / customer select an equipment / asset for lease.
- Lessor / Finance Company, then purchases the equipment / asset.
- Lessee / customer, then uses the asset during the lease period.
- Lessee / customer pay a series of rentals or installments for the use of equipment / assets.
- Lessor / Finance Company will then recover a large part or all of the cost of the equipment / asset plus earn interest from the rentals paid by the lessee.
- Lessee / customer has the option to acquire ownership of the equipment / asset (e.g. paying the last rental, or bargain option purchase price)
The finance company holds the legal right on the asset during the duration of the lease.
2. Operating Lease, is a lease contract that allows the use of an asset, but does not convey rights similar to ownership of the asset. An operating lease is not capitalized; it is accounted for as a rental expense.
US GAAP & IFRS with regard to Lease
Accounting for leases under US GAAP and IFRS is similar, but there are certain differences and US GAAP has more specific application guidance than IFRS. On general principle both the IFRS and US GAAP discuss the classification of the lease, as, either finance or operating lease and with this both separately discuss lessor and lessee accounting.
Significant differences are:
|Lease of land and Building||A lease for land and buildings that transfers ownership to the lessee or contains a bargain purchase option would be classified as a capital lease by the lessee, regardless of the relative value of the land. If the fair value of the land at inception represents 25% or more of the total fair value of the lease, the lessee must consider the land and building components separately for purposes of evaluating other lease classification criteria.||The land and building elements of the lease are considered separately when evaluating all indicators unless the amount that would initially be recognized for the land element is immaterial, in which case they would be treated as a single unit for purposes of lease classification. There is no 25% test to determine whether to consider the land and building separately when evaluating certain indicators.|
|Recognition of a gain or loss on a sale and leaseback when the leaseback is an operating leaseback||If the seller does not relinquish more than a minor part of the right to use the asset, gain or loss is generally deferred and amortized over the lease term. If the seller relinquishes more than a minor part of the use of the asset, then part or all of a gain may be recognized depending on the amount relinquished. (Note: Does not apply if real estate is involved as the specialized rules are very restrictive with respect to the seller’s continuing involvement and they may not allow for recognition of the sale.)||Gain or loss is recognized immediately, subject to adjustment if the sales price differs from fair value.|
|Recognition of gain or loss on a sale leaseback when the leaseback is a capital leaseback||Generally, same as above for operating leaseback where the seller does not relinquish more than a minor part of the right to use the asset.||Gain or loss deferred and amortized over the lease term.|
Accounting Treatment for Operating Leases
The accounting treatment for an operating lease is simple for both the lessor and the lessee. The lessee incurs an operating expense because of this the lease rental payable is written off in the income statement #account. In the notes the amount changed has to be disclosed by the lessee for the amount charged in the year and the amount of payments for, which the entity is committed to at year end. The lessor earns revenue from rentals on the asset and accordingly recognizes the lease rental receivable as income in the profit and loss account.
U.S. GAAP has clear rules for the difference between and capital and operating leases, whereas IFRS does not provide, but considers when transfer of risks to determine the classification between Operating/Capital lease category. In several cases a lease that is a financial lease under U.S. GAAP and a operating lease under IFRS.
New lease guidance is still under discussion that will require all operating leases to be capitalized on the balance sheets.
To illustrate accounting for lease transactions, we will use a simple case involving three parties:
- Farview Farms needs a small tractor. These tractors have an expected useful life of six years with no salvage value.
- Idaho First Bank & Trust which is currently charging 12% interest on long-term equipment loans.
- Troy Tractors, Inc., which manufactures the Model SX tractor at a cost of $40,000 and then sells them for $50,000. It also has a few units for trial use which rent for $500 per week.
If Farview Farms rents a tractor for one week from Troy Tractors, the journal entries would follow the usual pattern for a rental:
Comments –An operating lease is, in essence, a rental agreement. The lessor retains the risks and benefits of ownership.
Accounting treatment of finance leases – by the lessee
When a lessee enters into a finance lease contract, the lessee gets access to the risks and rewards of the assets and accordingly the lessee reflects substance by recognizing the asset in their own accounts and this is consistent with the ASB’s (Accounting Standard Board) Statement of Principles.
For various reasons either (or both) Farview Farms and Idaho First Bank & Trust might prefer a lease arrangement to an outright purchase/long-term loan. Assume that the bank agrees to purchase the tractor from Troy Tractors for $50,000. It then computes the payment on the lease required for it to earn its desired rate of 12% interest if the lease is written for five years with the first payment coming at the end of the first year (after harvest). [PVA = 50,000, n = 5, i = 12%, pymt = 13,871]. The lease agreement specifies that Farview Farms gets to keep the tractor at the end of the lease.