What it means
A company that needs a machine can buy it with borrowed money or lease it. If the lease runs for most of the machine's life, the payments add up to roughly its price plus interest, and the company can buy it for a nominal sum at the end, the two arrangements are economically the same: the company has the use of the machine for its life and is paying for it over time.
Accounting standards have long held that such a lease should be reported as what it is, an asset financed by debt, rather than as a series of rental expenses that keep both off the balance sheet. The traditional tests for a capital lease were whether the lease transfers ownership at the end, whether it contains a bargain purchase option, whether its term covers the major part of the asset's economic life (75% was the US bright line), whether the present value of the payments amounts to substantially all of the asset's fair value (90%), and whether the asset is so specialised that only the lessee can use it.
Meeting any test made the lease a capital lease. Leases designed to fail every test by a small margin, keeping billions of dollars of aircraft, shops and equipment off balance sheets, were the reason the standards changed.
Under IFRS 16, lessees no longer classify leases: every lease over twelve months (except low-value assets) is recognised as a right-of-use asset and a lease liability, with depreciation and interest in the income statement. Under ASC 842, lessees still classify leases as finance or operating using tests similar to the old ones, and both types go on the balance sheet; the difference is presentation, with finance leases showing depreciation plus interest (front-loaded expense) and operating leases showing a single straight-line lease cost.
Lessors under both standards continue to distinguish finance leases, where they derecognise the asset and record a receivable, from operating leases, where they keep the asset and record rental income. The accounting for a finance lease follows a set pattern.
At commencement, the lessee records the asset and liability at the present value of the lease payments, discounted at the rate implicit in the lease or the lessee's incremental borrowing rate. Each period, depreciation is charged on the asset over the shorter of the lease term and the asset's life (or the asset's life, if ownership will transfer), and the payment is split between interest on the outstanding liability and reduction of the principal.
Early in the lease, the interest element is large and the total expense exceeds the cash payment; later the reverse. The practical effects of recognising leases on the balance sheet are significant: higher reported assets and debt, changed gearing and return ratios, higher EBITDA (because the rental expense becomes depreciation and interest, both below EBITDA), and covenant definitions that had to be renegotiated when the standards changed.
Finance teams comparing companies across the transition, or across the two frameworks, need to know which rules the figures follow.
In practice
Real-world examples.
Example
An airline leases aircraft for twelve years, about 75% of their life, and recognises them as finance leases with $400 million of related debt.
Example
A retailer's ten-year store leases with no purchase option are operating leases under ASC 842 but still appear on its balance sheet as right-of-use assets.
Example
A lessor leasing a bespoke production line that only the lessee can use records a finance lease receivable rather than keeping the line as its own asset.
Think of it
“A capital lease is like a rent-to-own agreement. Even though you're making payments, you're essentially buying the item and account for it as yours.
Formula
Calculation
Initial Lease Liability = Present value of lease payments discounted at the rate implicit in the lease (or incremental borrowing rate)
Interest expense (period) = Opening liability x Interest rate
Principal reduction = Payment minus Interest
Depreciation = Right-of-use asset / Shorter of lease term and useful life
Worked example. A company leases a printing press with a fair value of $500,000 for five years at $115,000 a year payable in arrears, with a purchase option at the end for $1. The rate implicit in the lease is 5%. The press has a useful life of eight years.
The lease transfers ownership in substance (bargain purchase option; payments of $575,000 against a $500,000 asset), so it is a finance lease.
Initial measurement: present value of five payments of $115,000 at 5% = $115,000 x 4.329 = $497,900, plus $1 option (negligible): asset and liability of $497,900.
Year 1: interest = $497,900 x 5% = $24,900; principal reduction = $115,000 minus $24,900 = $90,100; closing liability = $407,800. Depreciation (ownership transfers, so over 8 years) = $497,900 / 8 = $62,200. Total expense year 1 = $87,100.
Year 2: interest = $407,800 x 5% = $20,400; principal = $94,600; closing liability $313,200; depreciation $62,200; total expense $82,600.
Years 3 to 5 continue: interest $15,700, $10,700, $5,500 (rounded, the last adjusted so the liability reaches nil). Total interest over five years = $77,100, and total payments $575,000 = $497,900 principal + $77,100 interest.
Comparison with the old operating-lease treatment: the company would have expensed $115,000 a year and shown nothing on the balance sheet. Under finance lease accounting, year-one expense is $87,100 (lower, because depreciation runs over eight years), EBITDA is $115,000 higher, and the balance sheet carries a $497,900 asset and a $407,800 liability at the end of year one. Gearing rises; return on assets falls; the true economics are unchanged.Case study
Seen in the real world.
A haulage company with 120 trucks had for years structured its vehicle leases to fall just outside the capital lease tests: terms of 70% of useful life, no purchase options, payments with a present value of 88% of fair value. The result was a balance sheet showing $6 million of assets and $4 million of debt for a business with $40 million of vehicles in use, and a bank covenant on debt to equity that was comfortably met. When the new leasing standard took effect, all 120 leases came onto the balance sheet: $34 million of right-of-use assets and $35 million of lease liabilities.
Reported debt rose sixfold, the covenant was breached on the first test date, and the bank, though it had always understood the fleet was leased, required a fee and a renegotiated covenant that excluded lease liabilities. EBITDA rose by $9 million because rental expense became depreciation and interest, and the company's bonus scheme, based on EBITDA, paid out on a change in accounting rules until the board amended it.
The finance director's report to the board observed that nothing about the business had changed and everything about its reported numbers had, and that the leases had been structured for twenty years to achieve an appearance the standard had now removed. The company's next fleet renewal was negotiated on economic terms alone, and turned out cheaper.
Watch out
Common mistakes.
- Assuming leases are off balance sheet. Under current standards almost all leases over twelve months are recognised by the lessee.
- Comparing EBITDA, gearing or return on assets across companies or periods without adjusting for the change in lease accounting.
- Using the wrong discount rate. The rate implicit in the lease should be used where determinable; otherwise the lessee's incremental borrowing rate, not a generic figure.
Questions
People also ask.
What is the difference between a capital lease and a finance lease?
None. Capital lease is the older US term; finance lease is the IFRS term and the term now used in ASC 842.
Do operating leases still exist?
For lessees under IFRS 16, effectively no: all significant leases are recognised the same way. Under ASC 842 the classification remains and affects expense presentation, but both types are on the balance sheet.
Is leasing still worthwhile if it goes on the balance sheet?
Often yes, for cash flow, flexibility, tax and access to assets without capital outlay. The decision should rest on economics rather than on accounting presentation.
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