Lease classification template illustrating accounting for leases and right-of-use assets.

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Leasing is important within many areas of the business as it doesn’t require large initial investments. It’s also beneficial for businesses in terms of cash flow, flexibility, convenience, and scalability. Start-ups or new small businesses often look for leasing options because their resources are limited, and the owners don’t want to invest so much money in acquiring assets to support the business in the beginning.

A leasing contract is an agreement in which a business has the right to use assets in return for regular payments over a particular length of time. Finance lease and operating lease are the two common accounting methods for asset leasing and are used for different purposes.

• Finance Leases
A finance lease is typically a full pay-out agreement; this means that the sum of the rentals includes the full capital cost of the asset plus the interest accrued.

Leases classified as ‘finance’ are counted as debt in a lessor’s finances and are treated like assets on a company’s balance sheet. This means that they depreciate and incur interest over time. Finance leases require the lessee to recognize interest expense and amortization expense, which means expenses will be higher at the beginning of the lease and decrease over time.

At the end of the lease, you can either hand the asset back and upgrade to the latest technology or extend the lease period for continued use of the current asset. Finally, ownership options may be available once the lease has been terminated at the end of the minimum lease term.

Under IFRS, lease classification has been abandoned as a practice, and all leases are treated as “Finance” leases.

Under ASC 842, Finance leases must now have at least one of the following conditions in their contract to be recognized as compliant with the US GAAP:

1. A transferal of ownership of an asset to the lessee at the end of the term of the initial lease.
2. The lessee is reasonably certain that they will exercise a purchase option at the end of the term of the lease.
3. The leased asset has no alternative use to the lessor at the end of the lease.
4. The lease term is a major part of the economic life of the underlying asset (most organizations use 75% to determine the “major part”).
5. The present value of lease payments is substantially all of the fair value of the leased asset (most organizations continue to use 90% to determine “substantially all”).

• Operating Leases
An operating lease is a contract where an owner of an asset, referred to as the lessor, gives someone, the lessee, access to that asset.

Typically, the lessee is able to use the asset for a period of time, which is less than the economic life of the asset, in exchange for the lessee making payments for an agreed-upon period of time. Operating leases are defined as a contract that permits the use of a certain asset without transferring the ownership right of that asset for any less than a major part of the asset’s life.

Any lease that does not cover the 5 conditions outlined in the Finance Leases above is classified as an Operating Lease.

This template is a useful tool assisting users in classifying the lease as Finance or Operating, performing an analysis of each lease type, and calculating the entries that should be recorded in the Financial Statements.

Template Contents:
• Lease Classification Tool
• Finance Leases Analysis incl. Existing and New Leases and Financial Statements entries
• Operating Leases Analysis incl. Existing and New Leases and Financial Statements entries
• Financial Statements (3-statement model) with Actual Figures and a 5-Year Forecast, including the Leases entries on Income Statement, Balance Sheet, and Cash Flow.

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