Lease Accounting Basics: Types of Leases and How They’re Classified

The classification of the lease in accounting is defined as the process of classifying lease as either finance lease or operating lease according to some outlined criteria of the accounting standards. Such classification could be critical in reporting of leases in a company's financial statements and could substantially influence the major financial ratios and decision making within a company.

The transfer criterion assists in the classification that a lease will shift substantially all of the risks as well as rewards of ownership of the lessor to the lessee. In that case it is a finance lease. Otherwise, this is perceived as an operating lease. When you know what the classification of lease is in accounting, the lessors and the lessees must sustain their transparency, be in accordance with regulations and report the financial soundness properly.

Types of Lease Classifications Under IFRS and GAAP

Both under IFRS (International Financial Reporting Standards) and the US GAAP (Generally Accepted Accounting Principles) leases are classified differently, whether you are a lessee or a lessor.

For lessees:

• Under IFRS 16, all the leases other than short-term and low value asset leasing will be reported as finance leases.
  
  

• The US GAAP (ASC 842) continues to have a separation between finance leases and operating leases which are accounted for differently.
  
  

For lessors, both IFRS and GAAP still recognize:

• Finance lease (or sales-type lease under GAAP)
  
  

• Operating lease
  
  

These types of lease classifications under IFRS and GAAP affect the asset, liability, revenues and expenses recorded in the financial statements.

Difference Between Finance Lease and Operating Lease

The main difference between finance and an operating lease is that of passing risks and perquisites of ownership. Finance lease is more or less an attempt of purchasing an asset on an installment basis whereby the asset is placed on the balance sheet along with appropriate lease obligation.

On the other hand, an operating lease is similar to a renting contract. It never leads to the transferring of ownership and is, under GAAP, handled differently in the financial statements of the lessee, although with ASC 842 (the new lease accounting standard) operating leases now must also be captured in the balance sheet, not entirely like finance leases, however.

For example:

• In a finance lease the asset is depreciated by the lessee and the interest on the liability is recognised.
  
  

• In operating lease, the lease expense is calculated directly on the straight line basis throughout the lease term.
  
  

This distinction in the structures of finance lease and operating lease is important in reporting and being in compliance.

Lease Classification Criteria Explained with Examples

In order to identify that the lease is a finance lease or operating lease, the following criteria should be assessed. Such lease classification criteria under IFRS 16 and ASC 842 incorporate:

• Sale of the property to the tenant when the lease period ends.
  
  

• The availability of a bargain purchase right.
  
  

• Lease period during the greater value of the utilization of the asset.
  
  

• A lease lease payments which are an amount that is a great part of the fair value of the asset.
  
  

• The property is sized up as such that it is specialized with no other application to the lessor.
  
  

A company based on leasing of equipment to a contract of 10 years, and the useful life of equipment is 12 years. In this case where a purchase option of the asset at a nominal price is provided under the lease and where the lease term is most of the useful life of the asset would most probably satisfy the requirements of a finance lease.

Conversely in case a company rents an office facility of two years with no option to buy the property and minimal commitments, then it can fall in the category of operating lease.

These are some of the examples of what should be used to classify leases in order to explain how the standards can be applied in practice.

How to Determine the Correct Lease Classification

The correct classification of a lease needs a careful consideration of the lease terms as well as comparison with the accounting criteria. Now, a short procedure of how to classify leases will be mentioned:

1. Analyze lease agreement terms: Determine how long it lasts, what you pay, any options to buy and terms to be fulfilled upon a lease expiry.
   
   

2. Compare with accounting criteria: Compare terms to the IFRS or the GAAP standards in determining whether risks and rewards of ownership are transfers.
   
   

3. Perform present value calculation: Compare between the payment of leases as present value and the fair value of the leased asset.
   
   

4. Consider asset specialization: If the asset is very specific or not very versatile it may suggest the finance lease.
   
   

The steps guarantee you will position yourself according to the right lease classification requirement to be compliant and include the lease correctly in your reporting.

Lease Classification Impact on Financial Statements

Lease classification effect on financial statements is gigantic. Not only the balance sheet is influenced by it but also income statements and cash flow statements presentations.

In this type of a finance lease, the lessor recognises:

• A balance sheet asset that is a right-of-use and a lease liability.
  
  

• The expense of depreciation of the asset.
  
  

• Interest cost on the liability.
  
  

In an operating lease, although one will also find lease assets and liabilities in the balance sheet under ASC 842, only one expense is recorded under the income statement.

Considering the financial analysis point of view, there are also several benefits that include the following:

• Finance leases add both liabilities and assets that could influence the levels of debt.
  
  

• Use of operating leases can lead to a more regular pattern of expense recognition, and increase earnings stability.
  
  

Investors and analysts find clues in classification of information concerning capital structure, obligations, and financial position of a firm. Correct classification of leases on the other hand is a key to transparency and credibility.

Conclusion

To sum it up, the classification of leases in accounting is a crucial process which floodlights the difference between finance and operating leases and has a direct influence on lease reporting as per IFRS and GAAP. Identification of the type of lease classifications, how such classification is determined and the effect on the financial statements would enable any business to be compliant and make sound financial decisions.

The difference between operating lease and finance lease is important in ascertaining the correct lease classification whether you are going through an evaluation of a new lease agreement or preparing the financial reports of your company. This is not only accounting knowledge but more crucial to CFOs, auditors and other business leaders in order to have an insight understanding on financial commitments.

In cases when your organization is frequently engaged in dealing with complex leases, it may be of great benefit to attend a professional training course or consult an accounting expert in order to properly classify the lease and comply with the recent application of standards.