Ifrs Finance Vs Operating Lease

Understanding the difference between finance and operating leases under IFRS is crucial for accurate financial reporting. IFRS 16, the current standard for lease accounting, significantly changed how leases are treated, especially for lessees. The primary distinction lies in who bears the risks and rewards incidental to ownership of the underlying asset. A finance lease (also known as a capital lease under other accounting standards) is, in essence, a purchase agreement disguised as a lease. If the lease transfers substantially all the risks and rewards incidental to ownership to the lessee, it’s classified as a finance lease. IFRS provides specific indicators, though no single indicator is definitive. These include: * The lease transfers ownership of the asset to the lessee by the end of the lease term. * The lessee has an option to purchase the asset at a bargain price. * The lease term is for the major part of the economic life of the asset (e.g., 75% or more), even if title is not transferred. * At the inception of the lease, the present value of the lease payments amounts to substantially all (e.g., 90% or more) of the fair value of the leased asset. * The leased asset is of such a specialized nature that only the lessee can use it without major modifications. For a finance lease, the lessee recognizes an asset (right-of-use asset) and a lease liability on the balance sheet. The asset is depreciated over its useful life or the lease term, whichever is shorter. The lease liability is amortized, with each payment split between principal and interest expense. The interest expense is recognized in the profit or loss statement. An operating lease, on the other hand, is a rental agreement. The lessee uses the asset, but the lessor retains the risks and rewards of ownership. Prior to IFRS 16, operating leases were often "off-balance-sheet financing," meaning they weren't recognized on the balance sheet. Under IFRS 16, the accounting for operating leases changed significantly for lessees. While the distinction between finance and operating leases remains for lessors, for lessees, most leases are now treated similarly to finance leases. Lessees must recognize a right-of-use asset and a lease liability on the balance sheet for virtually all leases (with limited exceptions for short-term leases, defined as 12 months or less, and leases of low-value assets). The key difference in treatment for lessees under IFRS 16 lies in the presentation on the income statement. For finance leases (and the majority of leases), the lessee recognizes depreciation expense on the right-of-use asset and interest expense on the lease liability. For short-term leases and leases of low-value assets, lessees can elect to expense the lease payments on a straight-line basis over the lease term. For lessors, the classification as a finance or operating lease determines how revenue is recognized. Lessors treat finance leases like a sale, recognizing revenue and a profit or loss at the lease commencement. Lessors treat operating leases by recognizing lease income over the lease term. In summary, while IFRS 16 narrowed the accounting gap between finance and operating leases for lessees by bringing most leases onto the balance sheet, the underlying economic substance remains. Determining whether a lease transfers substantially all the risks and rewards of ownership continues to be the key factor in determining its nature, particularly for lessors and regarding the presentation within the lessee's income statement.