International Accounting Standards Board states that “a lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time”.
Classification of Leases
The lease is classified as a finance one and an operating one.
Firstly, the classification is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. A lease that transfers substantially all the risks and rewards incidental to ownership is classified as a finance lease. Oppositely, it is an operating lease.
Secondly, IAS17, para. 10, states that “whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract”. Thus, a lease is categorized as a finance lease if the asset's ownership is transferred to the lessee when the lease period ends and if the lease includes any bargain purchase option. Besides, it needs to be aware of the major part of the asset's estimated useful life and if the minimum lease payments' present value is substantially equal to or over the asset's fair value. Any lease not under the above situations is classified as an operating lease.
Accounting Treatment and Disclosure
Regardless of whether the lease is a finance lease or an operating lease, both the lessor and the lessee should capitalize the asset by adding up the asset's cost plus any direct costs incurred in establishing the lease and depreciation charge should be computed by depreciating over the asset's estimated useful life or the lease period. Moreover, under a finance lease, the lessee should record the lease obligation as a liability in the balance sheet, and charges for the lease, if any, should be recognized during the accounting period over the corresponding lease term.
On the other hand, under an operating lease, the lease payment or income should be recognized as an expense or revenue in the income statement on a straight-line basis and disclosed separately the total amount of future lease payments to be paid within one year, in the second to fifth years and over five years.
In my opinion, there is no doubt that leasing is a very popular form of agreement because cash rental payments are spread over the lease period instead of paying a one-off lump-sum amount so that a firm is in a better cash flow position to prepare its forecast.
Additionally, the accounting policy: substance over form, which is an important part of the standard, stating that the transactions are recorded and presented in relation to their substance and economic reality and not only their legal form. Based on this approach, a company creates both assets and liabilities for the leased item. Thus, the standard becomes useful because the company can benefit from the depreciation allowance of leased assets, and the company can also take advantage of the tax benefits by deducting the cost of lease rentals from taxable income. As a result, when comparing finance lease and operating lease, although the accounting treatment of operating lease is simple, easy and quick, and it also does not distort the accounting ratio as it is an off-balance sheet item, finance lease is still comparatively favourable. Under the accounting treatment of finance lease, users of financial reports believe that the financial statement represent a true and fair view of the company's financial position. Shareholders can have a clearer view of resources available for creating future earnings and lenders can more easily assess a firm's ability to repay loans by means of the firm's assets available as security.
Therefore, from my point of view, this standard is important and useful when deciding a lease agreement.
There are many equivalent accounting standards set up by different professional bodies. When examining and comparing the standards with different professional bodies, there are still some differences. Taking U.S. GAAP into consideration of which the equivalent standard is FAS13, we can find dissimilarities in certain aspects.
Firstly, in the section of classification of leases, U.S. GAAP provides more specific quantitative requirements for determining a finance lease. If the lease term is equal to 75 percent or more of the leased assets' estimated economic life and the minimum lease payments' present value equals or is more than 90 percent of the leased assets' fair value, it is defined as a finance lease. U.S. GAAP also states that unless the renewal or extension of the lease was included in the original lease term, the renewal or extension of the lease according to the terms in the original agreement should be treated as a new lease.
Secondly, in the section of finance lease recognition, U.S. GAAP states that the initial direct costs incurred by the lessee are charged to the income statement as an expense but not recognized as an asset as stated in IAS. Besides, under U.S. GAAP, the minimum lease payments' present value is computed by the lessee's incremental borrowing rate, and in certain conditions, the discount rate can be substituted by the implicit rate calculated by the lessor. Moreover, under IAS, a lessee will assess at each reporting date over the leased asset's useful life whether the leased asset is impaired while under U.S. GAAP, assets with limited useful lives are evaluated for impairment only if there is an impairment indicator and thus it can simplify the transactions recording procedures.
Thirdly, in the section of operating lease recognition, under U.S. GAAP, there is no exception for the scheduled rental payments to be increased to reflect the expected effects of inflation and so the lease payments can be kept constant. In addition, initial direct costs incurred by the lessor are presented separately and allocated to income statement in proportion to the recognition of rental income.
Fourthly, regarding the sale and leaseback transactions in a finance lease, U.S. GAAP specifies that any gain or loss on disposal must be amortized in proportion to the amortization of the leased asset while in an operating lease, U.S. GAAP states that any profit or loss is deferred and amortized in proportion to rental expenses.
In conclusion, U.S. GAAP clearly explains the accounting treatments and includes much more detailed and comprehensive guidance. Besides, it provides more explicit numeric thresholds for determining a lease which are useful and valuable.
Deloitte Touche Tohmatsu 2010, ‘Summaries of International Financial Reporting Standards', viewed 15 February 2010, <http://www.iasplus.com/standard/ias17.htm>
Elliott, B & Elliott J 2009, Financial accounting and reporting, 13th edn, Prentice Hall
‘International Accounting Standard 17', viewed 15 February 2010, <http://eifrs.iasb.org/eifrs/bnstandards/en/ias17.pdf>
McGladery & Pullen 2009, ‘Leases : IFRS vs. U.S. GAAP', viewed 15 February 2010,
The American Institute of Certified Public Accountants 2010, ‘IFRS for SMEs — U.S. GAAP Comparison Wiki', viewed 15 February 2010, <http://wiki.ifrs.com/Leases>