Classification of Equipment Leases in Accounting

Introduction

Companies often rent things like machinery, vehicles, computers, and industrial tools instead of buying them outright in today's business world. Leasing gives you more options, costs less up front, and makes it easier to get to cutting-edge technology. But from an accounting point of view, not all leases are handled the same way. A significant inquiry emerges: ought an equipment lease to be regarded solely as a rental expense, or should it be classified as an acquisition of the asset?

Meaning of equipment lease

An equipment lease is a contract in which one person, called the lessor, gives another person, called the lessee, the right to use an asset for a set amount of time in exchange for regular payments. The lessor may still own the asset legally, but the lessee gets the economic benefits from using it.
In accounting, how these kinds of leases are handled doesn't just depend on how the contract is written. It depends on the economic substance of the deal, which means who really owns the asset and takes on the risks and rewards that come with it.

Whether a lease is treated as a rental or a purchase change how a company looks on paper

- Balance sheet impact: It is basically a list of what the company owns and owes on a particular day. Now that the lease is treated as a purchase, the equipment is shown as an asset, and the future lease payments are shown as a liability. This makes the balance sheet bigger and more realistic.

- Profit and loss is how much money is earned and spent by the company in a year.

- Financial ratios are the numbers used to judge the company’s debt, assets, and profit. In the case of rent, no assets are shown, and hence no liability, which means the company has less debt and is healthy, which can be misleading sometimes.

- Stakeholder decisions: The stakeholders must know all the information about the company before really investing into it.

Difference between renting and buying

When the lessor keeps most of the risks and rewards of ownership and the lessee only has temporary usage rights, the lease is considered a rental (operating lease). When the lessee effectively gains control over the asset and reaps most of the economic benefits, even if legal ownership doesn't change hands right away, a lease is considered a purchase (finance lease or capital lease).

The principle of "substance over form" is important in accounting standards. This means that the real economic effect of a transaction is more important than how it is described in law.

Indicators to determine whether a lease is a rental or a purchase

Ownership Transfer In case the lease contract unambiguously mentions that the title of the asset will go to the lessee after the lease period, the transaction will be accounted for similarly to a sale. The reason for this is that the lessee at last gets the right of ownership over the asset.

Lease Duration vs Useful Life Where the lease period largely coincides with the asset's useful life, it implies that the lessee is utilizing the asset nearly throughout its working life. For instance, if a piece of machinery is capable of running for ten years, and it is leased for eight or nine years, it becomes practically worthless when the lease expires. Hence, the lease is treated as a purchase since the lessee has capitalized on nearly all the advantages that are associated with the asset's ownership.

Lease Payments Present Value When the sum of the lease payments, expressed in today’s terms (present value), approaches the market value of the asset, it signifies that the lessee is virtually paying the full price of the equipment.

Bargain Purchase Option An arrangement whereby the lessee gets the right to purchase the asset at the end of the lease term for a very low price as compared to its expected market value is treated as a sale.

Risk and Reward Distribution Housing the majority of the risks and rewards connected to the asset means that the lease is accounted for like a purchase.

Cancellation Conditions In case a lease is very difficult to cancel or if cancellation is subject to very high penalties, it is a strong indicator that the lessee is tied to the asset for a long period. Such leases that cannot be cancelled are akin to the purchase of an asset by taking out a loan, as the lessee is under obligation to keep making payments irrespective of the situation.

In India, lease accounting is determined by Ind AS 116, which is influenced by the international standard IFRS 16. This standard has made a huge impact on the manner in which leases are accounted for in a company’s books. In the past, most leases were simply treated as rent and were thus not included in the balance sheet. Ind AS 116 has launched the concept of Right-of-Use (ROU), which is based on the actual usage of the asset rather than legal ownership. In this scenario, if a company leases an asset, it has to enter two things in its accounting: one is a right-of-use asset, which indicates the entitlement to use the equipment, and the other is a lease liability, signifying the responsibility to make the future lease payments. Only short-term leases and leases of low-value assets are allowed as exceptions. This treatment of leases has resulted in most equipment leases being reported like purchases, thereby increasing the transparency and comparability of financial statements.

Conclusion

The classification of equipment leases is based on economic substance, not legal form. Companies apply key indicators and Ind AS 116 to make sure their financial reporting is correct, which allows stakeholders to evaluate the actual financial situation and risk.