Lesson 1 of 8 · All lessons in this module
- What a lease is and how it is classifiedVideo lesson
- Lessee accounting: the IFRS model and US GAAP finance leasesVideo lesson
- US GAAP operating leases and the effect on ratiosVideo lesson
- Lessor accounting: finance versus operating leases
- Defined contribution and defined benefit pension plansVideo lesson
- Share-based compensation: stock grants, options and SARsVideo lesson
- Presentation and disclosure: leases, pensions and share-based pay
- Integrated cases: reading the pension, lease and share-based pay notes
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Lesson 1 of 8 · 12 min
What a lease is and how it is classified
A lease gives the user control of a specific asset for a period in exchange for payments, and it is a finance lease if it looks like buying the asset, otherwise an operating lease.
In short
- A lease conveys the right to use an asset for a period in exchange for payment. The user is the lessee; the owner is the lessor.
- A contract is (or contains) a lease only if it identifies a specific asset, gives the customer largely all the economic benefits from it, and lets the customer direct its use.
- Lessees like leases for low upfront cash, cheap (secured) financing and less ownership risk; lessors earn interest and widen their market.
- A lease is a finance lease if any one of five criteria is met (same under IFRS and US GAAP, same for lessee and lessor); otherwise it is an operating lease.
- Lessees may simply expense payments straight line for leases of 12 months or less (IFRS and US GAAP) and, under IFRS only, for low-value assets (up to about USD 5,000). Lessors get no such exemption.
When is a contract a lease?
A lease is a contract that hands over the right to use an asset for a period of time in return for consideration. The party that uses the asset and pays is the lessee; the party that owns the asset and receives the payments is the lessor.
Three tests must all be passed. The contract must point to a specific underlying asset. The customer must have the right to obtain largely all of the economic benefits from that asset during the term. And the customer, not the supplier, must decide how and for what purpose the asset is used.
Compare renting a named delivery van for your exclusive use, where you plan the routes, with paying a courier firm to move your parcels. The first is a lease. The second is a service contract: no specific van is identified and you do not get the van's benefits, only a delivery.
For the lessee, a lease behaves like buying the asset with a loan. For the lessor, it is an investment and a sales tool, because many customers prefer paying in instalments.
Why lease rather than buy?
From the lessee's side, leasing has three main attractions. Little or no down payment is needed. The financing is usually cheap, because a lease is effectively secured borrowing: if the lessee stops paying, the lessor takes the asset back, so the implied interest rate is typically below the rate on an unsecured loan or bond. And the lessee avoids some ownership risks such as obsolescence (though lessors price that risk into the payments).
From the lessor's side, leasing earns interest income over the term and enlarges the market for its product: customers who could not pay the full price up front can still use the asset and pay over time.
Finance or operating? The five criteria
Some leases are really purchases in disguise: a car leased for its whole useful life, with payments worth its full price, has effectively been bought on credit. Others are short rentals of long-lived assets. A lease that resembles a purchase is a finance lease; every other lease is an operating lease.
The lease is a finance lease if any one of the five criteria below is met. If none is met, it is an operating lease. The criteria are the same under IFRS and US GAAP, and lessee and lessor apply the same tests.
- Ownership of the asset transfers to the lessee by the end of the term.
- The lessee has a purchase option it is reasonably certain to exercise.
- The lease term covers a major part of the asset's useful life.
- The present value of the lease payments equals or exceeds substantially all of the asset's fair value.
- The asset is so specialised that it has no alternative use to the lessor.
Who reports what: the map of the module
The accounting depends on three things: are you the lessee or the lessor, do you report under IFRS or US GAAP, and is the lease finance or operating. Lessor accounting is substantially the same under both frameworks. For lessees, IFRS uses one model for all leases, while US GAAP uses two models, one for finance and one for operating leases.
Before any of that, a lessee checks the exemptions. A lease of 12 months or less (both frameworks), or of a low-value asset worth up to about USD 5,000 new (IFRS only), may be kept off the balance sheet, with payments simply expensed on a straight-line basis. Lessors cannot use these exemptions.
| Party | IFRS | US GAAP |
|---|---|---|
| Lessee | Single model for all leases (finance-style) | Finance lease model and operating lease model |
| Lessor | Finance lease or operating lease | Finance lease (sales-type or direct financing) or operating lease |
| Lessee exemptions | Term ≤ 12 months; low-value asset | Term ≤ 12 months only |
Formula
- PV-to-fair-value test
If the present value of the payments covers substantially all of the asset's fair value, the lessee is effectively paying for the whole asset.
Worked examples
Example 1 Lease or service contract?
Brattli Bygg AS signs two contracts. (1) It rents crane number 7 from a supplier for 3 years; only Brattli may use it and Brattli decides which sites it works on. (2) It pays a logistics firm to deliver building materials to its sites each week, using whichever trucks the firm chooses. Which contract contains a lease?
Example 2 Applying the PV test
Norrsken Data AB leases a server system for 4 years. Payments are SEK 250,000 at the end of each year, the rate implicit in the lease is 7%, the system's fair value is SEK 870,000 and its useful life is 7 years. There is no ownership transfer, no purchase option and the system is standard equipment. How should the lease be classified?
On the exam
Expect a short scenario asking whether a contract is a lease and, if so, finance or operating, often with the PV-versus-fair-value test; also which exemptions exist and that IFRS uses one lessee model while US GAAP uses two.
- Thinking all five criteria must be met. One is enough for a finance lease.
- Assuming the low-value asset exemption exists under US GAAP. It is IFRS only; the 12-month exemption exists under both.
- Believing lessors can use the short-term exemption. Exemptions are for lessees only.
- Treating a contract for a service (shipping goods) as a lease when no specific asset is identified.
Check yourself
Q1A lease term covers 3 years of an asset's 15-year useful life, there is no purchase option or ownership transfer, and the PV of payments is 25% of fair value. The lease is most likely:
Q2Payments of EUR 40,000 are due at the end of each of the next 3 years, discounted at 5%. The asset's fair value is EUR 112,000. The PV of the payments as a share of fair value is closest to:
Q3Under IFRS, which lessee lease may be expensed straight line without recognising a right-of-use asset?
Q4Which statement about lease classification is most accurate?
Q5From the lessee's perspective, the interest rate implicit in a lease is typically lower than on an unsecured bond mainly because:
Answer the 5 questions: +10 XP for each one you get right first time.
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