Finance Lease vs Operating Lease: Understanding the Differences under IFRS

Introduction to Leasing: Operating Lease vs Finance Lease

Leasing is a common practice in the business world, allowing companies to use assets without the need for upfront purchase. Two popular types of leases are finance leases and operating leases. Understanding the differences between these two lease types is crucial for financial reporting and decision-making.

What is the difference between finance lease and operating lease?

A finance lease is a type of lease that transfers substantially all the risks and rewards of ownership to the lessee. The lessee essentially assumes ownership of the leased asset for the lease term. On the other hand, an operating lease is a lease that does not transfer substantially all the risks and rewards of ownership to the lessee.

What is the difference between finance lease and operating lease journal entries?

The accounting treatment for finance leases and operating leases differs. For finance leases, the lessee records the leased asset as an asset and the lease liability as a liability on the balance sheet. The lessee also recognizes interest expense on the lease liability and depreciation expense on the leased asset. On the other hand, for operating leases, the lessee does not record the leased asset or lease liability on the balance sheet. Instead, the lessee recognizes lease expense on a straight-line basis over the lease term.

What is the difference between a true lease and a finance lease?

A true lease and a finance lease are essentially the same. A true lease is another term used to refer to a finance lease. Both terms describe a lease that transfers substantially all the risks and rewards of ownership to the lessee.

What is the difference between operating lease and finance lease right of use asset?

Under the new lease accounting standards, both operating leases and finance leases require the recognition of a right-of-use (ROU) asset. The difference lies in the subsequent measurement of the ROU asset. For finance leases, the ROU asset is measured at cost less accumulated depreciation and impairment. In contrast, for operating leases, the ROU asset is measured at the present value of lease payments plus initial direct costs.

Distinguishing Between Operating and Finance Leases

When deciding whether a lease should be classified as an operating lease or a finance lease, certain criteria need to be considered. These criteria include:

• The transfer of ownership at the end of the lease term
• The bargain purchase option
• The lease term in relation to the economic life of the asset
• The present value of lease payments in relation to the fair value of the asset
• The nature of the leased asset and its specialized use

Accounting Treatment of Leases Under IFRS and US GAAP

The accounting treatment of leases under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP) also differs. Under IFRS, the distinction between operating leases and finance leases has been removed, and all leases are accounted for as finance leases. On the other hand, US GAAP still maintains the distinction between operating leases and finance leases.

Real-World Examples: Operating Lease vs Finance Lease

Let's consider two real-world examples to illustrate the differences between operating leases and finance leases:

1. Example 1: Company A leases office space for a period of 5 years. The lease contract does not transfer ownership of the building to Company A, and it does not meet any of the criteria for a finance lease. Therefore, this lease is classified as an operating lease.
2. Example 2: Company B leases a delivery truck for a period of 3 years. The lease contract transfers ownership of the truck to Company B at the end of the lease term, and it meets the criteria for a finance lease. Therefore, this lease is classified as a finance lease.

Compliance with New Standards: Operating Lease vs Finance Lease ASC 842

Both operating leases and finance leases are subject to new lease accounting standards, such as ASC 842 in the United States. These new standards require lessees to recognize lease assets and lease liabilities on the balance sheet for most leases, including operating leases.

Capital Lease vs Finance Lease: Dissecting the Differences

Capital leases and finance leases are often used interchangeably, but there is a slight distinction. A capital lease is a type of lease that meets certain criteria set out by the Internal Revenue Service (IRS) for tax purposes. On the other hand, a finance lease is a type of lease that transfers substantially all the risks and rewards of ownership to the lessee.

Conclusion: Navigating the Complexities of Lease Accounting

Understanding the differences between finance leases and operating leases is essential for financial reporting and decision-making. The accounting treatment, lease classification criteria, and compliance with new lease accounting standards all play a significant role in lease accounting. By being familiar with these concepts, companies can accurately report their lease transactions and make informed decisions regarding leasing arrangements.