An operating lease involves a lessor, the owner, who engages in an arrangement to rent out the asset to receive lease rentals from a lessee. The lessee, in turn, benefits from utilizing the assets. These contracts can vary from short-term to long-term. The ownership & title of assets remains with Lessor. Before IFRS 16 - Leases, operating leases were treated as "Off the Balance Sheet." This classification occurred because the total obligations arising from the agreement were not recognized as a liability. A classic example was evident in the airline industry, where companies leased aircraft for a certain period. The lease payments were not fully reflected as liabilities, leading to an understatement of the actual financial obligations.

Operating leases are akin to rental agreements, where lease expenses are treated as operating costs in books of accounts, appearing in Income statement.

A finance lease is a long-term contract, whereas an operating lease is a short-term contract.In the finance lease, the ownership of the asset is transferred to the lessee. But, it not the case in the operating lease. In the finance lease, the lessee takes care of or maintains the asset, whereas, in the operating lease, the lessor takes care of or maintains the asset. In the finance lease, the lessee can buy the asset for a price less than the asset’s fair market value. On the other hand, in the operating lease, the lessee does not get a choice to buy the asset for a price less than the asset’s fair market value.

IFRS 16: Leases was introduced to mitigate off-balance sheet financing, which does not faithfully represent the financial position of an entity. It introduced a single lessee model requiring lessees to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is deemed "low value." The UK Endorsement Board and Financial Reporting Council are proposing to bring FRS 102 into alignment with IFRS 16 to come into effect on January 1, 2026.

The main distinctions between operating and finance leases in final accounts lie in how they are treated on the balance sheet and income statement. Operating leases are typically considered off-balance sheet items, impacting the income statement through lease expenses. In contrast, finance leases are treated as on-balance sheet liabilities, affecting both the balance sheet and income statement. Each has its own set of accounting rules, influencing financial reporting and ratios. It's crucial for businesses to understand and communicate these differences for a transparent financial picture.

Finance leases are more like ownership of the underlying assets, where lessee not only gets the right to use the assets but also bear the risks and rewards of the ownership. Finance leases are reflected on balance sheet, both as on asset as Right to Use Assets and on liability as Lease liability, giving a comprehensive summary of lessee financial obligations.

Unlike operating lease, in finance lease, lessor transfers the ownership & title of the assets to lessee at the end of lease term. Lessor's real role is more of financer/funding the transactions with a motive to earn interest on funds lended and receive lease payment over the lease term. Such kind of transactions forms part of the balance sheet in the books of lessee as - a. leased asset as non-current assets. b. lease liability as current as well as non-current c. depreciation on the lease assets in P&L d. interest expense included in P&L Finance leases are considered under the definition of IFRS 16 with certain exemptions and exceptions.

Finance leases are those leases in which ownership of the asset is with lessee, where the lessee has an option to buy the asset after the lease term. While accounting for finance lease, a net present value of all lease payments is calculated using the incremental borrowing rate. A Right of Use Asset and Lease liability is created by the same amount calculated as above. Right of Use Asset is a Non Monetary asset which is depreciated over the lease period and Lease Liability is a liability for payment of rent which is increased each year by the interest calculated on discounting rate used above, and reduced by rent paid.

The main differences between operating and finance leases in the final accounts lie in asset and liability recognition. In a finance lease, the lessee recognizes both the leased asset and corresponding liability on the balance sheet, reflecting ownership risks and rewards. Depreciation and interest expenses are recorded in the income statement. Conversely, operating leases do not require asset or liability recognition on the balance sheet; instead, lease payments are expensed as incurred, impacting the income statement without altering the balance sheet significantly. This distinction influences financial ratios and perceived leverage.

In jurisdictions that apply IFRS, when accounting for Leases, IFRS 16 does not allow for any distinction between operating lease and finance lease for the Lessee - all leases are accounted for as RoU Asset and Liability except for Low-Value items and those with short lives ( 12 months or less ) For Lessor accounting, however, the initial requirements in IAS 16 have been essentially maintained in IFRS 16 where there's a distinction between Finance Lease and Operating Lease and specific guidance on how each should be accounted for appropriately.

IFRS accounts for only one type of lease for lessees: Finance leases, requiring lessees to recognize leases on the balance sheet with an exception for low-value leased assets.(defined as an asset having an individual value of less than $5,000 but each company can determine their own low-value threshold) But US GAAP distinguishes between finance and operating leases, impacting lease classification and subsequent accounting where a lease is evaluated in comparison to five criteria and if a lease meets any of the five criteria, it is classified as a finance lease. Both operating and finance leases are recorded on the balance sheet, the difference between classification primarily relates to the recognition of expenses related to the lease.

Under IFRS, there is no distinction between operating lease and finance lease in the books of the LESSEE. The lessee recognises the right of use asset and lease liability for all types of leases EXCEPT for those of short live or low value items. For the lessor, the assessment still exists to determine finance lease or operating lease. Few distinguishing considerations include: 1. Does the customer have the right to obtain substantially all the economic benefits of the asset throughout the period of use? 2. Does the lessee or the lessor have the right to direct how and for what purposes the asset is used? 3. Did the lessee design the asset (or specific aspects) in a way that predetermines how and for what purposes the asset will be used?

Under International Financial Reporting Standards (IFRS), there is no differentiation between operating leases and finance leases in the financial records of the lessee. The lessee recognizes a right-of-use asset and lease liability for all lease types, except for those involving short-term or low-value items. However, for the lessor, it is required to determine whether a lease is a finance lease or an operating lease. This involves considering factors such as whether the customer has the right to obtain most of the economic benefits of the asset throughout the lease term and whether the lessee or lessor has the right to direct the asset's use and purpose.

Navigating the accounting for leases requires an understanding, as standards vary across jurisdictions. The classification and recognition in IFRS and US GAAP depend on the - Definition of leases - Classification of leases - Recognition of leases and Right-of-use assets - Treatment of initial direct costs - Subsequent measurement of lease liabilities For example a company entering into a lease agreement for equipment for 5 years. Under IFRS, the classification would depend on the transfer of risks and rewards, while under US GAAP, the focus would be on whether the lease transfers substantially all the risks and benefits of ownership.

The minimum disclosures for leases in line with IFRS 16: - Nature and term of lease - Amount and timing of lease payments - Carrying amount and depreciation of Right-of-use assets - Interest rates used and maturity analysis. - Modification and changes in lease - Details of variable lease payments.

−If a company applies IFRS 16 early, then it discloses this fact. −If a company uses the practical expedient for lease definition, then it discloses this fact. −If a company uses any of the practical expedients relating to operating leases, a statement of which practical expedients have been used. −Disclose the weighted-average incremental borrowing rate used to measure lease liabilities at the date of initial application. −Provide an explanation of any difference between: - the present value of the operating lease commitments disclosed in the previous set of annual financial statements, discounted at the rate used to calculate lease liabilities at the date of initial application; and - the lease liabilities recognized at that date.

It’s not just about accounting - it’s about strategy. >Finance Lease: Think of this as the long game. You get the benefits of owning the asset (eventually) and have control over it, which is great if you’re looking for stability and long-term use. But with that comes more complexity in your books and possibly higher initial costs. >Operating Lease: This is more like a rental. You get flexibility, predictable costs and less hassle - perfect if you need something for the short term or want to avoid the commitment of ownership. It might cost more in the long run, and you won’t end up owning the asset. With new accounting standards like IFRS16 & ASC 842, ultimately, it’s about what aligns best with your business goals and financial strategy.

Merits and demerits of operating lease: 1. An operating lease for office allows a startup business to easily relocate or expand its operations without the constraints of property ownership. 2. Selecting an operating lease for equipment instead of purchasing outright preserves capital. 3. Operating leases restrict modifications to leased assets. 4. Leasing assets like machinery may result in higher cumulative lease payments over time compared to ownership. Merits and demerits of finance lease: 1. A finance lease for a company vehicle provides ownership benefits. 2. Finance leases often allow to claim tax deductions on both interest & depreciation. 3. Ownership through finance leases contributes to higher asset and equity ratios.

While short-term leases can be excluded for all standards’ balance sheet application, the definition of a short-term lease differs between these standards. 👉Per IFRS 16, a short-term lease is a lease with a term of 12 months or less that does not include a lease purchase option. 👉Per ASC 842, a short-term lease is a lease with a term of 12 months or less that does not include an option to purchase the underlying asset the lessee is reasonably certain to exercise. ✅At last, for use of interest rate in the calculation of the lease liability and ROU asset balances, IFRS don’t allow the risk-free rate but per US GAAP an option is available for non-public companies to use the risk-free rate in their calculations.

Accurately classifying leases is crucial for understanding your financial health and performance. If you're unsure about the classification of a lease, consult with a qualified accountant. By understanding these key distinctions and practical examples, you can navigate the lease accounting landscape with confidence and ensure your financial statements accurately reflect your true financial position.

When differentiating between operating and finance leases, consider their accounting treatment, lease duration, risks, benefits, and lease payments. Operating leases are off-balance sheet, offering flexibility in duration, while finance leases require asset recognition and liability disclosure. Assess who bears risks and benefits—lessor in operating leases, lessee in finance leases. Examine how lease payments are allocated in financial statements—operating lease payments as operating expenses, finance lease payments as interest and principal. This evaluation ensures accurate financial reporting and compliance with accounting standards.