In today's business world, to own an asset can be a challenge to the business owner. Therefore, choosing the right type of financing to purchase asset can help to reduce the burden. A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time (AS 19, p 286). There are two important types of leases namely finance lease and operating lease. In general view, a finance lease is a lease that transfers significantly all the risks and rewards incident to the ownership of an asset, whereas an operating lease is a lease other than finance lease (Accounting Policy, 2009).
The financial leases are long-term, non-cancellable leases where any risk in the use of the asset is borne by the lessee whereas the operating leases are short term, cancellable leases where the risk of obsolescence is tolerated by the lessor. The comparison between the financial lease and operating lease can be made by comparing the agreement that made by the lessee and the lessor. According to Mukhopadhyay (1995), finance leases are differ from operating leases over four tests in which when the term of the lease exceeds 75 percent of the life of the asset, in case if there is a transfer of ownership at the end of the lease, or in another way, if there is an option to purchase at a discounted price or if the payment terms of the lease exceed 90 percent of the lease's fair market value. If any of these conditions are met, the lease is considered a finance lease. Finance leases are treated like a loan, the fixed assets are debited by the value of the lease and long-term liabilities are credited for the lease obligations. In an operating lease, a company pays a periodic fee for the use of some benefit. The benefit can be tangible, such as office space, or intangible, such as a patent. Besides that, the company acquiring the lease takes no ownership over this benefit, only the ability to use it. In result, the accounting rules for operating leases differ from ownership and the leasing costs are directly expensed as incurred.
In financial statement of AS 19 (p 291) stated that, the lessee should recognize the lease as an asset and a liability. Such recognition should be at an amount equal to the fair value of the leased asset at the inception of the lease. However, if the fair value of the leased asset exceeds the present value of the minimum lease payments from the standpoint of the lessee, the amount recorded as an asset and a liability should be the present value of the minimum lease payments from the standpoint of the lessee. In contrast, lease payments under an operating lease should be recognized as an expense in the statement of profit and loss on a straight line basis over the lease term unless another systematic basis is more representative of the time pattern of the user's benefit. For operating leases, the lease payments (excluding costs for services such as insurance and maintenance) are recognized as an expense in the statement of profit and loss on a straight line basis unless another systematic basis is more representative of the time pattern of the user's benefit, even if the payments are not on that basis.
Besides that, finance leases are treated like debt in accounting and can enhance a company's book value. The book value equals the total assets minus total liabilities. Additionally, firms can fully remove depreciation and lease payments against their income taxes, while only lease payments are deductible with operating leases. Finance leases often include special purchase arrangements for firms at the end of the agreement. In comparison, since there is no ownership involved, operating leases offer a great deal of flexibility. For example, a small business doesn't need to worry about equipment becoming obsolete. A company can simply lease newer equipment. The ability to directly expense leasing costs provides some accounting benefit. When a company owns an asset, accounting rules dictate that the property, plant or equipment must be depreciated and held on the balance sheet for the asset's useful life. In effect, this ties up the company's cash flow and leverages the company to financiers. Operating leases are not subject to these constraints (Ramanujam, 1995).
On the other hand, according to Betsy Gallup (2012), the tax benefit of an operating lease over a finance lease depends on the type of asset leased. If the asset is expected to become obsolete before the entire value can be depreciated off the books, then the company may garner a greater tax break from the direct expense of each lease payment. Companies can offset operating expenses dollar for dollar against income earned. The amount of depreciation that can be expensed is controlled by IRS (Internal Revenue Services) regulations and is based on the IRS's determination of what the normal-use lifespan of the item should be. On the other hand, if the lease is a finance lease, the interest paid on the lease each year can be expense and depreciate the cost of the asset over the life of the asset. Before leasing equipment, consider the long-term benefits each way and whether the estimated life for the use of the equipment correlates to the IRS guidelines. If not, an operating lease may be a better option for the lessee.
In Australia Accounting Standards Board (2007), AASB 117 Leases prescribes the appropriate accounting treatment and disclosure requirements for leases in the financial statements of lessees and lessors. At the inception of the lease, the lease is classified either as an operating or finance lease, with the lease classification depending on the substance of the transaction rather than the form of the contract. The Standard provides examples and indicators of situations that individually or in combination would normally lead to a lease being classified as a finance lease.
The accounting treatment of a sale and leaseback transaction by a seller-lessee depends upon the type of lease involved the sale and leaseback transaction resulting in a finance lease. Any excess of sales proceeds over the carrying amount shall be deferred and amortized over the lease term. Besides this, sale and leaseback transaction resulting in an operating lease and the transaction is established at fair value. Whereas for operating leases, if the fair value at the time of the sales and leaseback transaction is less than the carrying amount of the asset, a loss equal to the amount of the difference between the carrying amount and the fair value is recognized immediately (AASB 117, p 20).
According to Malaysia Accounting Standards Board (2000), MASB 10 Leases, classifies leases as either a finance lease or an operating lease and prescribes, for lessees and lessors, the appropriate accounting policies and disclosures to apply in relation to finance and operating leases. MASB 10 supersedes MASB Approved Accounting Standard IAS 17, Accounting for Leases adopted previously by the MASB. Besides this, MASB 10 defines finance leases as those that transfer substantially, all risks and rewards incidental to ownership of the leased asset to the lessee. All other leases are operating leases. This definition is premised on the substance of the transaction as opposed to the form that a lease contract may take. MASB 10 prescribes that where a sale and leaseback results in a finance lease, any excess of sale proceeds over carrying amount should be deferred and amortized over the lease term. Guidance is also provided in the case where a sale and leaseback results in an operating lease.
In conclusion, the types of leases can be differentiated in term of assets, agreements, what other countries say about it. In order to make the differences between the finance lease and operating lease, the different accounting and approaches are important to use for classify them.
