Lease Accounting 101

Classifying leases as finance or operating is fundamental to how companies manage leased assets and report them under today’s U.S. GAAP standards. Regardless of whether a company is entering into a traditional lease or a sale-leaseback, understanding the distinctions is essential for accurate financial reporting and decision-making.

What is a finance lease?

Leases are classified as ‘finance’ when they have characteristics that make them similar to financing the purchase of the underlying asset. To qualify as a finance lease, one or more of the following criteria must be met:

• Transfer of Ownership: Ownership transfers to the lessee at the end of the lease
• Lease Purchase Option: The lessee has an option to buy the asset (and likely will)
• Lease Term: The lease term represents most of the asset’s remaining economic life (typically 75% or more)
• Present Value: The present value of the lease payments (and any residual value guarantee) is equal to or exceeds substantially all of the asset’s fair market value (typically 90% or more)

Under a finance lease, the lessee is deemed to have control over the asset. As such, finance leases are accounted for as if the lessee has ownership of the asset. Accordingly, the lessee recognizes the rent expense as a bifurcated expense between interest expense and depreciation on the income statement as well as a right-of-use asset and lease liability on the balance sheet. Given the nature of the arrangement, finance leases require careful consideration due to the impact on said financial statements.

What is an operating lease?

An operating lease is much more like a typical lease arrangement, where the lessor permits the lessee to utilize an asset for a set period of time. Under older accounting standards, these assets and related liabilities were not recorded on balance sheet, but that changed in 2016 with ASC 842, in which lessees are now required to bring operating leases on their balance sheet. Leases are categorized as operating if none of the four criteria for finance leases listed above are met.

With an operating lease, ownership is not transferred at the end of the lease period. This carries with it the risk that when the lease term ends, a company may be asked to leave or offered unfavorable terms to renew the lease. However, this could also be a plus if the company is looking to move locations.

On financial statements, operating leases are accounted for as a right-of-use asset and a lease liability, with all rent expense being recorded as an operating cost.  

Special considerations for sale-leasebacks

Sale-leasebacks have an added layer to consider. For the transaction to qualify as a true sale under ASC 842, the sale-leaseback must be classified as an operating lease. If it is classified as a finance lease for any of the reasons above, it is treated as a ‘failed sale.’

When the sale fails, the seller/lessee:

• Does not derecognize the asset on its balance sheet and instead records the proceeds as a loan
• Pays down the loan through lease payments, which are split into principal and interest expense. The interest rate is based on the seller’s incremental borrowing rate

W. P. Carey can help

Understanding the differences between finance and operating leases is crucial for businesses, especially those considering a sale-leaseback. With both lease types now displayed on balance sheet, it’s important for companies to understand the nuances of each so they can best adhere to accounting standards and make well-informed decisions about their lease agreements.

W. P. Carey has more than 50 years of experience executing sale-leasebacks and helping companies structure customized leases that make the most sense for their business. While W. P. Carey can help, lessees should consult their accounting professional to address their specific needs.