In: Root » » Market and Finances » Operating leases are not capitalised and are treated as rentals
What are leases?Leases allow a company to use some of its operating fixed assets (i.e., buildings, plant and other fixed assets) under a rental system. In certain cases, the company may purchase the asset at the end of the contract for a predetermined and usually very low amount. Leases pose two relatively complicated problems for external financial analysts:
How are they accounted for?A lease is either a finance lease or an operating lease. A finance lease5 according to the IASB is ‘‘a lease that transfers substantially all the risk and rewards incident to ownership of an asset. Title may or may not eventually be transferred.’’ An operating lease is a lease that is not a finance lease. Under IAS, finance leases are capitalised, which means they are recorded under fixed assets and a corresponding amount is booked under financial debt. The lease payments to the lessor are treated partly as a reduction in financial debt and partly as financial expense. The capitalised asset under a finance lease is depreciated over its life. Accordingly, no rental costs are recorded on the income statement, merely financial and depreciation costs. Operating leases are not capitalised and are treated as rentals.Sale and leaseback transactions, where an asset is sold only to be taken back immediately under a lease, are restated as follows: any capital gain on the disposal is deferred and recognised in income over the duration of the lease for finance leases or immediately for operating leases. How should financial analysts treat them?As the reader can see, the distinction between a finance lease and an operating lease is fairly vague; it remains nonetheless a vital one for analysing the real level of a group’s indebtedness. US GAAP contain precise criteria (see p. 959) used in Europe. But they may be too precise, as companies wanting to avoid capitalising leases in their balance sheet may artificially structure leases in a way to avoid being qualified as a finance lease, so as not to show additional liabilities. Eventually, accountants may decide that all leases are financial leases. Such a decision is not as dramatic as it seems at first sight since, when a lessee signs a contract with a lessor and pays it a rent, this commitment gives rise to a liability, at least from a financial point of view. So the reader should beware of a company with large operating leases. They add fixed costs to its income statement and raise its breakeven point. |
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