Operating leases allow the lessee to use the property for only a portion of its economic life. They are accounted for as contracts.

• The lessee reports only the required lease payments as they are made. There is no balance sheet recognition of the property.
• All of the risks and rewards of ownership remain with the lessor. For the lessor:
  • Payments received are recognized as income.
  • The property remains on the balance sheet and is depreciated over time.
  • Over the life of the lease, periodic lease payments from the lessee are reported as rental revenue on the income statement. They are recorded as operating cash flows.

In an operating lease the lessee is not seen as becoming the owner of the asset. In a finance lease the lessee is seen as becoming the owner.

Finance leases involve effective transfer of all risk and benefits of property to the lessee. For accounting purposes the transaction is treated as though the lessor has granted the lessee a loan to purchase the asset. The lessee recognizes the asset as a loan on its balance sheet and treats the lease payments as part of interest expense and part of repayment of the principal on the loan. The lessee then also recognizes depreciation on the asset.

Benefits

Generally, lessees prefer leases to be classified as operating leases. They do not have to recognize the asset and loan on their balance sheet, although they still receive all of the benefit of using the asset. Therefore, operating leases result in higher profitability ratios and reduce reported leverage for lessees.

Generally, lessors prefer leases to be classified as finance leases. This allows them to potentially recognize a profit on the sale of the asset, though the substance of the transaction is similar to installment sales or financing. This also allows them to be able to derecognize the asset on their balance sheet.

Finance or Operating Leases?

To determine whether a lease is a finance or operating lease, you need to follow the rules in (U.S.) SFAS 13 or IAS 17. Even if a lease contract states that it is an operating lease, if the lease meets the requirements for a finance lease it needs to be accounted for as such.

Under U.S. GAAP, a lease meeting any of the following criteria at inception must be classified as a finance lease by the lessee:

• The lease transfers ownership of the property to the lessee at the end of the term.
• The lease contains a bargain purchase option that the lessee may purchase the leased asset for a price that is significantly below its fair market value at the end of the lease term.
• The lease term is equal to 75% or more of the asset's economic life.
• The present value of the minimum lease payments (MLPs) equals or exceeds 90% of the asset's fair market value, using the lessee's incremental borrowing rate or the implicit rate of the lease.

The provisions of IAS 17 are less precise. That standard defines a finance lease as one that transfers substantially all the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred.

If a lease does not meet any of the four criteria above, it is classified as an operating lease by the lessee. SFAS 13 mandates the use of the straight-line method of recognizing periodic payments unless another systematic basis provides a better approach. As a result, for leases with rising rental payments, lease expense and cash flow will not be identical.

From a lessor's perspective, a lease is classified as a finance lease if, at its inception, it meets any of the above four criteria and both of the following two revenue recognition criteria:

• Collectability of lease payments is reasonably predictable.
• There are no significant uncertainties regarding the amount of un-reimbursed costs yet to be incurred by the lessor. That is, future costs are reasonably predictable, so the lessor's performance is substantially complete.

A lease that does not meet any of the four criteria is classified by the lessor as an operating lease.

Example

A company leases a machine with a six-year life and a cost of $10,000 for 4 years with annual payments of $2,500 due at the end of each year. The lessee can borrow at 4% per annum. Calculate if the lease should be treated as an operating lease or capital lease.

1. Does the lease transfer ownership of the property to the lessee at the end of the lease term? No, the asset is only leased for 4 years out of its possible 6-year useful life and the asset is given back to the lessor. This requirement is not met.

2. Does the lease contain a bargain purchase option? Not from the information available in the question. Thus this requirement is not met.

3. Is the lease term equal to 75% or more of the estimated economic life of the leased property? The lease is for 4 of the 6-year useful life, which equates to 66.6% (4/6) of the estimated economic life. This requirement is not met.

4. Does the present value of the minimum lease payments (MLPs) equal or exceed 90% of the fair value of leased property to the lessor? The cost of the asset is $10,000. In order to determine the present value of the minimum lease payments you need to know the borrowing cost of the lessee. If you assume that the lessee is able to borrow at 4% for the 4 years, the present value is $9,074. This is 90.7% (9074/10000) of the fair value of the leased asset. The present value of the minimum lease payment exceeds 90% of the fair value of the leased asset to the lessor and thus qualifies for recognition as a capital lease.

The lease is recognized as a finance lease by the lessee.