Financial Leasing and Operating Leasing are different accounting methods in the world of asset finance and accounting treatment of leasing.
A finance lease is a method of financing assets where the lessor (or owner) remains the legal holder of the asset for the duration of the lease, and where the risks and returns get transferred to the lessee (or user). In simpler terms, the assets remain the property of the owner and the lessee pays for the hire of those assets.
Contrastingly, in an operating lease, the lessor allows the lessee to make use of an asset for a shorter period that runs less than its full economic life. This occurs without any transfer of ownership rights.
IAS 17 stipulates the appropriate accounting policies and disclosures to be applied in relation to financial leases for lessors and lessees. In this article, we will find out how financial reporting for finance leasing occurs under the IAS17.
Substance Over Form Concept
IAS 17, Leases applies the ‘substance over form’ concept where it is deemed necessary to account for the overall financial reality of an entity – its substance – rather than accounting for the legal form and transaction of an entity. The result of this is that financial reporting becomes more reliable and genuine.
Essentially, the legal form of a transaction can be used to hide the true intent of that transaction. The substance over form concept conveys the full financial and transactional nature.
How Does IAS 17 Work?
IAS 17 states that there are two different types of lease: a finance lease and an operating lease.
In order to classify the type of lease in question, one must first consider the information provided within the scenario to establish whether the risks and rewards associated with owning the asset affect the lessor or the lessee. Indeed, if the risks and rewards lie with the lessee then it is a finance lease. On the other hand, it is an operating lease when the risks and rewards are not taken by the lessee.
Finance Lease Indicators
Generally, the main factors that indicate that a lease is a finance lead are:
- the lease transfers ownership of the asset to the lessee by the end of the lease term
- the lessee has the option of purchasing the asset at a price that is expected to be sufficiently lower than its fair value
- the lease term is for the major part of the economic life of the asset, even if the title is not transferred
- at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset
- the leased assets are of a specialised nature
Finance Lease Accounting
The initial accounting is that the lessee should capitalise on the finance leased asset and set up a lease liability for the value of the specified asset. The accounting for this includes:
- Dr Non-current assets
- Cr Finance lease liability
The lower fair value of the asset or the present value of the minimum lease payments should be used.
Following the initial capitalisation of the leased asset, depreciation should be charged on the asset over the shorter of the lease term or the useful economic life of the asset. The accounting for this will be:
- Dr Depreciation expense
- Cr Accumulated depreciation
When it comes to a lease agreement, a finance cost automatically comes up with the transaction.
For instance, a company could choose to either purchase an asset with an economic life of four years for €10,000 or else lease it for four years, paying a rental fee of €3,000 per year. If the latter leasing option is opted for, a company will have spent €12,000 in total over a four-year period to use the asset. This means that the finance charge would amount to an extra €2,000 (€12,000 – €10,000).
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