Finance Leases vs. Operating Leases - IFRS 16 Examples

Introduction

A finance lease is a lease that transfers substantially all risks and rewards of ownership to the lessee. The lessor in a finance lease derecognises the asset and recognises a receivable. All other leases are operating leases, where the asset is retained on the lessor's balance sheet and lease income is recognised on a straight-line basis.

IFRS 16, which replaced IAS 17 in January 2019, introduced significant changes to the accounting treatment of leases. The difference between finance leases and operating leases remains crucial for lessors, but for lessees, the standard requires most leases to be recognised in the statement of financial position.

This article explores the key differences between finance and operating leases under IFRS 16 and forms part of our full IFRS 16 guide.

Definitions

The fundamental distinction between finance and operating leases lies in the transfer of risks and rewards:

Finance Lease

A lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset.

Operating Lease

A lease that does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset.

Treatment for Lessees

Under IFRS 16, lessees no longer classify leases as finance or operating leases. Instead, they:

• Record a right-of-use asset
• Recognise a corresponding lease liability

The following leases are exempt from the treatment above, and are still recognised through profit and loss:

• Short-term leases (12 months or less)
• Leases for low-value assets

The distinction between finance and operating leases is no longer relevant for lessees, as both types are recognised similarly to finance leases under the previous standard (IAS 17).

Treatment for Lessors

Classification Criteria

A lease is classified as a finance lease if it meets one or more of the following criteria:

Finance Lease Treatment

• Derecognise the leased asset
• Recognise a receivable equal to the net investment in the lease
• Record interest income over the lease term
• Capitalise initial direct costs (excluding manufacturer or dealer lessors)
• For manufacturer or dealer lessors: recognise revenue, cost of sales, and profit/loss

Operating Lease Treatment

• Retain the underlying asset in the statement of financial position
• Recognise rental income on a straight-line basis
• Capitalise initial direct costs as part of the underlying asset
• For right-of-use assets sublet as operating leases: apply IAS 40 Investment Property

Practical Example: Classifying a Lease

Scenario

ABC Leasing Company leases manufacturing equipment to XYZ Manufacturing with the following terms:

• Asset fair value: R1,000,000
• Lease term: 8 years
• Asset economic life: 10 years
• Annual lease payment: R150,000 (payable in arrears)
• Residual value guarantee: None
• Purchase option: Lessee can purchase for R50,000 at end of lease (significantly below expected fair value of R200,000)
• Discount rate: 8%

Analysis

Let's apply the classification criteria:

1. Ownership Transfer? No - ownership doesn't automatically transfer at lease end.

2. Purchase Option Reasonably Certain? Yes - R50,000 purchase option when asset will be worth R200,000 is a bargain purchase option that's reasonably certain to be exercised.

3. Lease Term vs Economic Life? 8 years / 10 years = 80% - covers major part of economic life.

4. Present Value Test:

• PV of lease payments: R150,000 × 5.747 (PV annuity factor, 8 years, 8%) = R862,050
• Plus: PV of purchase option: R50,000 × 0.540 (PV factor, 8 years, 8%) = R27,000
• Total PV: R889,050 = 89% of fair value

5. Specialised Asset? Not mentioned, assume no.

Conclusion

This lease meets multiple criteria (bargain purchase option, major part of economic life, and substantially all fair value). ABC Leasing should classify this as a finance lease.

Accounting Treatment

At lease commencement, ABC Leasing will:

Dr Net investment in the lease                889,050
Cr Equipment                                 1,000,000
Cr Profit on disposal                          (To be calculated based on cost)

Over the lease term:

• Recognise interest income using the effective interest method
• The interest income will be front-loaded (higher in early years)
• Each lease payment will reduce the net investment in the lease

If this were an operating lease instead:

• Equipment remains on balance sheet at R1,000,000
• Depreciate over 10 years: R100,000 per year
• Recognise rental income: R150,000 per year (straight-line)
• Net income per year: R50,000 (R150,000 - R100,000)

Practical Challenges

Key Implementation Challenges

• Exercising judgment in lease classification
• Collecting comprehensive lease data
• Managing multiple lease agreements
• Determining appropriate discount rates
• Handling lease modifications

Conclusion

IFRS 16 has significantly changed lease accounting, particularly for lessees. While lessors continue to distinguish between finance and operating leases, lessees now recognise most leases on their balance sheet. Understanding these requirements is crucial for:

• Accurate financial reporting
• Compliance with accounting standards
• Effective lease management
• Stakeholder communication

For any clarification, guidance, or feedback on our article, please reach out to us on insight@leash.co.za.