- Distinguish between a finance lease and an operating lease
ASU 2016-02, which was effective for publicly traded companies after Dec. 15, 2018, states that all leases, whether classified as operating or capital leases (called “finance leases” under the new standard), create a right-of-use asset and a liability that should appear on the lessee’s balance sheet.
In general terms:
- A capital lease or finance lease is one where the lessee records the leased asset as if he or she purchased the leased asset using funding provided by the lessor.
- An operating lease functions much like a traditional lease, where the lessee pays to use an asset but doesn’t enjoy any of the ownership economic benefits nor incur any of the risks that come with ownership.
Under an operating lease, a single lease cost, generally allocated on a straight line basis over the lease term, is presented in the income statement. Under a finance lease, we recognize interest on the lease liability and the lease expense is typically higher in the earlier years of the lease term.
Note: The FASB made these recent changes to more closely align with IFRS, which does not distinguish lease classifications for a lessee. All leases are accounted for similar to the way GAAP accounts for finance leases.
Lessor accounting is also slightly different between the two bases of accounting. A lessor (the company leasing the asset to some other company) has three categories to determine classification under US GAAP: an operating, a direct financing, or a sales-type lease. If a lessor has a direct financing lease, the selling profit is deferred at the commencement date and included in the measurement of the net investment on the lease. A lessor only has two categories to classify a lease under IFRS: an operating or a finance lease. Selling profit may be recognized at the lease commencement for all finance leases.
In this section though, we will be focusing on the liability created by the lessee (the company leasing the asset from some other company).
For the lessee, there are five criteria for determining if a lease is a finance lease:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset unless the commencement date of the lease falls at or near the end of the economic life of the underlying asset.
- The present value of the sum of lease payments and any residual value guaranteed by the lessee not already reflected in lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
Under the old standard, a capital lease (now called finance lease) created a debt and an asset, and an operating lease did not. Now, the only difference between the two is that a finance lease creates an asset and a corresponding debt, just like a purchase with a note payable, while an operating lease creates a liability with an offsetting asset called a “right-of-use” asset.
In short, most leases are recorded as a liability that is reported like debt with a corresponding asset:
|Lease Type||Balance Sheet||Income Statement||Profile of total lease cost|
|Finance Lease||ROU Asset and Lease liability||Operating expense: amortization of ROU Asset
Interest expense: interest expense on lease liability
|Operating Lease||ROU Asset and Lease liability||Operating expense: lease expense||Typically straight-line|
To illustrate the complexity of this issue, see A Roadmap to Applying the New Leasing Standard—a 908 page “summary” of the rules around recognizing and presenting lease transactions.