Financial Reporting: Leases

By Ben R. Punongbayan

In simple terms, a lease is a contract for renting an asset for a periodic payment of money over a period of time. The common understanding of a lease is that the lessor receives a sum of money periodically and records the amount in his books as income. He continues to keep the rented asset in his books. On the other hand, the lessee records his payment in his books as expense and that is all.

But not in the realm of correct accounting.  

If one takes a closer look at leasing, it is in a broad sense an option to finance the acquisition of the use of an asset. Generally, the potential acquirer evaluates his option of whether to buy or lease the asset. The potential entity-acquirer, of course, evaluates its options based on several factors, such as the impact of each option on its cash flow, bottom-line and financial position.  

Similarly, a potential investor of an entity would look for the existence of leases taken by the investee and would include in his own evaluation the impact of such leases on the investee’s financial leverage (debt–equity relationship) and earnings.

The more apparent the effects of leases are shown on an entity’s financial statements, the better it would be for potential investors and other interested parties -- they will not need to do more research and analysis.

The current standard on lease accounting deals with such needs of preparers and users of financial statements. It requires that a lease be classified as either a finance lease or an operating lease.

A finance lease is “…a lease that transfers substantially all the risks and rewards incidental to ownership of an asset.”  In layman’s terms, the transferee (lessee) is responsible for the cost of maintenance, risk of loss or damage, etc. In return, the lessee enjoys all the benefits derived from the use of the asset. Such classification applies whether or not the lessee has a right to purchase the asset at the end of the lease term. On the other hand, an operating lease is simply “… a lease other than a finance lease.”

A finance lease must be accounted for by the lessee as a purchase of the leased asset and by the lessor as a sale of goods. The effect is quite substantial, especially for the lessee: the lessee has to record the transaction as an asset with a corresponding liability. The value of the transaction, therefore, adds to the lessee’s recorded liabilities and impacts the entity’s debt-equity ratio and, consequently, its borrowing capacity.

Lease contracts have varying terms and conditions, including the timing and amounts of periodic payments, residual values, etc.  If a lease is classified as a finance lease, the value of the asset to be recorded shall be the fair value of the leased asset or, if lower, the present value of the minimum lease payments. I wrote about fair value earlier so I will no longer comment on that. As to the present value of the minimum lease payments, the discount factor that should be used is the interest rate implicit in the lease. In the Philippines, the implicit rate is normally known or determinable. However, if the implicit rate cannot be determined, an equivalent interest rate, including its determination, is provided for in the standard.  

To sum up, in a finance lease, the lessee has to record the lease as an asset, recognize a liability, take up depreciation on the asset, and record the equivalent interest expense. The lessor, on the other hand, simply records a sale, removes the leased asset from its books, and recognizes interest income.

An operating lease is simpler. The lessee recognizes its lease payment as expense and the lessor records such payment as revenue. However, for both lessee and lessor, the lease expense and income, respectively, have to be recognized on a straight-line basis.  If there are escalations in rent payment and rent-free periods, the total rent for the lease term should be averaged out and the annual average recorded as expense or income each year during the term of the lease.

Those are the current requirements.

There is, however, an ongoing international project to revise substantially the accounting standard on lease. The revision is focused on requiring lessees to recognize an asset for its right to use the leased asset and to record a liability to pay rentals on practically all leases, including those presently classified or classifiable as operating lease. Similarly, the lessor will need to make a reciprocal treatment. This revision was proposed in an effort to make it easier for users to understand the financial statements of entities with lease contracts. It has been observed that in much of the leasing activity in the world in 2008, the assets and liabilities arising from such contracts were not shown in the lessee’s financial statements. While presently, certain information about operating leases are disclosed in the lessee’s financial statements, potential investors still  need to conduct further research and analysis to determine the effects of such leases on an entity’s financial leverage and earnings.

When I was a young accountant, many people thought that accounting was very difficult. I told them, “Nah, it is easy!” Nowadays?  I’ve changed my mind.


Mr. Punongbayan is the founder of audit, tax and advisory services firm Punongbayan & Araullo, a member firm of Grant Thornton International Ltd.