Leases
A lease is a contract in which the lessor (owner of the asset) grants the lessee (user of the asset) the right to use an asset for a specified period in exchange for periodic payments.
Leases are widely used to finance assets without purchasing them, including real estate, equipment, vehicles, and machinery.
1. Difference Between Finance Lease and Operating Lease
Finance leases and operating leases are two different ways of accounting for lease agreements, with key differences in their financial and accounting treatment.
1.1. Finance Lease (Capital Lease)
A finance lease is considered equivalent to purchasing an asset with financing. Under this type of lease, the lessee assumes most of the risks and rewards associated with asset ownership.
Characteristics:
- Recognized as both an asset and a liability on the lessee’s balance sheet.
- The asset is depreciated like any other fixed asset.
- A financial liability (lease obligation) is recorded.
- Two expenses are recognized in the income statement: depreciation expense and interest expense.
- Typically, at the end of the lease, the lessee has the option to purchase the asset at a reduced price.
Example: A transportation company signs a finance lease agreement to acquire a fleet of trucks for five years. The contract states that at the end of the lease term, the company can buy the trucks for a symbolic amount. Since the asset is used for most of its useful life and the company assumes the risks and rewards, this qualifies as a finance lease.
1.2. Operating Lease
An operating lease is more like a traditional rental agreement, where the lessor retains the risks and rewards of asset ownership.
Characteristics:
- Not recognized as an asset under US GAAP (but under IFRS 16, it must be recorded on the balance sheet).
- Only a single lease expense is recorded in the income statement.
- No financial liability is associated.
- The lessee does not assume ownership risks, and there is generally no purchase option at the end of the lease.
Example: A technology company rents an office building for three years with no purchase option. The company has no control over the asset after the contract ends and simply pays a monthly rent. In this case, the contract qualifies as an operating lease.
Key Differences Summary
| Finance Lease | Operating Lease | |
|---|---|---|
| Asset Ownership | Transfers to the lessee or is used for most of its useful life. | Remains with the lessor. |
| Accounting Treatment | Recognized as an asset and a liability (on the balance sheet). | Recorded as lease expense (off-balance sheet under US GAAP, but on-balance sheet under IFRS 16). |
| Expense Recognition | Depreciation of the asset + interest expense on the liability. | A single lease expense. |
| Impact on EBITDA | Higher EBITDA, as depreciation and interest do not affect EBITDA. | Lower EBITDA, as the entire lease expense is recorded directly. |
| Purchase Option | Usually present, or the asset is used for most of its useful life. | No purchase option. |
- Finance Lease: Treated as a financed purchase, with an impact on the balance sheet and financial expenses.
- Operating Lease: Similar to a traditional rental, with less impact on the balance sheet (except under IFRS 16).
2. Differences in Lease Accounting under GAAP (US GAAP) and IFRS (IFRS 16)
| Criteria | IFRS 16 (International Financial Reporting Standards) | US GAAP (United States Generally Accepted Accounting Principles) |
|---|---|---|
| Lease Classification | Does not distinguish between operating and finance leases: all leases are recorded on the balance sheet (except for certain short-term or low-value contracts). | Distinguishes between finance leases (capital leases) and operating leases. |
| Balance Sheet Recognition | All leases create a right-of-use asset and a lease liability on the balance sheet. | Only finance leases are recorded on the balance sheet; operating leases are recognized as an expense in the income statement. |
| Expense Recognition | A depreciation expense on the asset and an interest expense on the lease liability are recorded. |
-Finance leases: Recorded the same way as under IFRS. -Operating leases: A single lease expense is recognized in the income statement, without separating interest and depreciation. |
| Impact on EBITDA | Higher EBITDA since the lease expense is split into depreciation and interest (which do not affect EBITDA). | For operating leases, the lease expense directly reduces EBITDA. |
| Short-term Leases | Can be excluded from the balance sheet if they last less than 12 months without a purchase option. | Can be excluded from the balance sheet if they meet certain criteria. |
| Financial Impact | Greater impact on the balance sheet as more contracts are recognized as financial liabilities. | Lower balance sheet impact due to the distinction between operating and finance leases. |
- IFRS 16 requires all leases to be recognized on the balance sheet, eliminating the distinction between operating and finance leases.
- US GAAP retains the distinction between finance (capital) and operating leases, allowing many lease agreements to remain off the balance sheet.
- The treatment under IFRS 16 tends to increase financial debt and affect key financial indicators such as EBITDA and leverage compared to US GAAP.