Lease

Lease Lessor Lessee Operating Lease Finance Lease Accounting Standards IAS 17 FRS 102
A lease is a contractual agreement in which a lessor grants the lessee the right to use an asset for a specified period in return for specific rental payments. While the lessor retains ownership rights, the lessee gains usage rights.
On this page

What is a Lease?

A lease is a contractual agreement where one party, the lessor, permits another party, the lessee, to use a specific asset for a defined time in exchange for periodic payments. Ownership of the asset remains with the lessor, while the lessee gains the right to use the asset for the lease term. Depending on the lease type, it can impact financial statements differently.

Detailed Explanation

Leases are pivotal in both personal and business settings, often used for vehicles, real estate, machinery, and equipment. The agreement stipulates all terms including duration, payment amounts, and conditions for asset use. There are generally two types of leases:

  1. Operating Lease: The lessor retains a substantial part of the risks and rewards of asset ownership. Payments are treated as operational expenses.
  2. Finance Lease: The lessee assumes most risks and benefits, often covering most of the asset’s lifecycle. Such leases appear on the balance sheet.

Classification Under Standards

  • Financial Reporting Standard (FRS) 102: Applicable in the UK and Republic of Ireland, it offers guidance on how leases should be reported.
  • International Accounting Standard (IAS) 17: This provides an international framework for accounting for leases, ensuring consistency in lease reporting.

Examples

  1. Vehicle Leasing: A company leases a fleet of cars for its sales team. The lessor owns the vehicles, but the company pays periodic lease payments for their use.
  2. Real Estate Leasing: A retailer leases a store location in a shopping mall. The lease terms allow the lessee to operate a store without owning the property.
  3. Equipment Leasing: A manufacturing firm leases machinery needed for production rather than purchasing it outright. The lease payments can be lower than the cost of buying the equipment.

Frequently Asked Questions (FAQs)

Q1: What determines whether a lease is an operating lease or a finance lease?

A1: The classification hinges on the extent to which risks and rewards incidental to ownership lie with the lessor or lessee.

Q2: Can a lease agreement be modified?

A2: Yes, lease agreements can be renegotiated or modified based on mutual consent. These modifications might affect lease classification and accounting treatment.

Q3: Do lease payments affect a company’s cash flow statements?

A3: Yes, payments under operating leases are typically shown in the operating activities section, while finance lease payments get split into principal (financing activities) and interest (operating activities).

Q4: What happens at the end of a lease term?

A4: The lease may end, be renewed, or, in some cases, the lessee might purchase the asset at its residual value under a finance lease agreement.

Q5: How does IFRS 16 differ from IAS 17 regarding leases?

A5: IFRS 16 requires nearly all leases to be reported on the balance sheet, eliminating most off-balance-sheet operating leases, providing more transparency compared to IAS 17.

  • Lessor: The party who owns the asset and grants the lease.
  • Lessee: The party who gains the right to use the asset.
  • Operating Lease: Lease where lessor retains significant ownership risks.
  • Finance Lease: Lease where lessee bears most ownership risks.
  • Residual Value: The asset’s estimated value at the end of the lease.

Online References

Suggested Books for Further Studies

  1. “Wiley IFRS 2023: Interpretation and Application of International Financial Reporting Standards” by PKF International Ltd.
  2. “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
  3. “Lease Accounting: A Practitioner’s Guide” by Barry J. Epstein

Accounting Basics: “Lease” Fundamentals Quiz

### Who retains ownership of the asset under a lease agreement? - [x] The lessor - [ ] The lessee - [ ] Neither party - [ ] Jointly owned > **Explanation:** The lessor retains ownership of the asset during the lease period, while the lessee has the right to use the asset. ### Which type of lease typically appears on the balance sheet of the lessee? - [ ] Operating Lease - [x] Finance Lease - [ ] Short-Term Lease - [ ] Service Lease > **Explanation:** Finance leases typically appear on the balance sheet of the lessee as they bear most risks and rewards related to the asset. ### What does the Payment made under an operating lease represent? - [ ] Capital expenditure - [x] Operating expense - [ ] Financing expense - [ ] Prepaid expense > **Explanation:** Payments made under an operating lease are treated as operating expenses, affecting the income statement. ### According to IAS 17, which component of the lease is not transferred to the lessee under an operating lease? - [ ] Benefits - [ ] Usage rights - [x] Risks and rewards - [ ] Tax obligations > **Explanation:** Under an operating lease, the major risks and rewards of ownership remain with the lessor. ### In what scenario can a lessee purchase the asset at the end of the lease term? - [ ] Any lease - [ ] Operating Lease - [x] Finance Lease - [ ] Short-term lease only > **Explanation:** Under a finance lease, the lessee often has the option to purchase the asset at the end of the lease term. ### When adjusting financial statements, where are operating lease payments typically reflected? - [ ] Financing activities - [x] Operating activities - [ ] Investing activities - [ ] Off-balance sheet > **Explanation:** Operating lease payments are usually reflected in the operating activities section of the cash flow statement. ### Why might a company prefer an operating lease over purchasing an asset outright? - [ ] Depreciation benefits - [x] Lower initial costs - [ ] Immediate ownership benefits - [ ] Equity financing > **Explanation:** Companies might prefer operating leases due to lower initial costs and greater flexibility compared to purchasing the asset outright. ### According to FRS 102, what primary distinction affects the classification of a lease? - [x] Risk and reward distribution - [ ] Payment frequency - [ ] Lease duration - [ ] Residual value estimation > **Explanation:** The primary distinction affecting lease classification is the distribution of risks and rewards between the lessor and lessee. ### What kind of accounting treatment is IAS 17 concerned with? - [ ] Calculating residual values - [x] Lease accounting - [ ] Inventory management - [ ] Depreciation methods > **Explanation:** IAS 17 specifically provides guidelines for accounting treatments of both finance and operating leases. ### What benefit does IFRS 16 aim to provide that IAS 17 did not? - [ ] Reducing lease expenses - [ ] Simplifying lease agreements - [ ] Off-balance-sheet transparency - [x] Greater transparency in lease accounting > **Explanation:** IFRS 16 aims to provide greater transparency in lease accounting by requiring nearly all leases to be reported on the balance sheet.

Thank you for exploring the detailed world of lease accounting and challenging yourself with our quiz questions!

Tuesday, August 6, 2024
Lease Bonus
Learning Curve
Operating Lease January 1, 1
Bargain Renewal Option January 1, 1
Finance Lease January 1, 1
Asset Classification January 1, 1
Capital Lease January 1, 1
Contingent Rent January 1, 1
Financial Lease January 1, 1
Lease Bonus January 1, 1
Leaseback January 1, 1
Leveraged Lease January 1, 1

Accounting Terms Lexicon

Discover comprehensive accounting definitions and practical insights. Empowering students and professionals with clear and concise explanations for a better understanding of financial terms.