Lessor accounting

The lessee's world has one model under IFRS and Ind AS and two under US GAAP. The lessor's world has three outcomes under US GAAP and two under IFRS and Ind AS, with a further split inside the finance-lease outcome that turns on who the lessor is. The reason is straightforward. A lessee is always financing the use of an asset. A lessor may be financing the sale of an asset it manufactures, financing the purchase of an asset it bought to lease out, or renting out an asset it intends to keep.

How is a lease classified for the lessor?

Classification asks one question. Does the lease transfer substantially all the risks and rewards incidental to ownership of the underlying asset to the lessee? If it does, the lease is a finance lease under IFRS and Ind AS, or a sales-type lease under US GAAP. If it does not, it is an operating lease.

The indicators are the same list you met from the lessee's side, and under US GAAP they are the same five criteria that classify a lessee's finance lease. Ownership transfers by the end of the term. There is a purchase option reasonably certain to be exercised. The term is a major part of the asset's remaining economic life. The present value of the lease payments plus any residual value guaranteed by the lessee amounts to substantially all of the fair value. The asset is so specialised that it has no alternative use to the lessor at the end of the term. US GAAP offers seventy-five percent and ninety percent as one reasonable approach to "major part" and "substantially all"; IFRS and Ind AS give no numbers at all and require judgement supported by the whole picture.

Sales-type vs direct financing lease

US GAAP then splits the finance-lease outcome in two, and the split is about who the lessor is. A sales-type lease arises whenever any one of the five criteria is met, and the lessor recognises any selling profit at commencement. A lessor that bought the asset at its own fair value has no selling profit to recognise, so the label bites hardest on a manufacturer or dealer. A direct financing lease arises in the narrower situation where the classification criteria are not met on their own but the present value of the payments plus a residual value guaranteed by a third party amounts to substantially all of the fair value, and it is probable the lessor will collect. Selling profit in that case is deferred and recognised over the lease term. None of it is taken at commencement. IFRS and Ind AS do not use the direct financing label at all; they distinguish the manufacturer or dealer lessor, who recognises selling profit at commencement, from every other finance lessor, who has none because it bought the asset at fair value.

What does classification change?

Three consequences of classification, before any arithmetic.

The asset leaves the balance sheet or it does not. A finance lessor derecognises the underlying asset and replaces it with a receivable. An operating lessor keeps the asset and keeps depreciating it. That single difference moves total assets, asset turnover and the entire capital-intensity picture of the business.

Revenue arrives at once or over the term. A manufacturer-dealer lessor books revenue and cost of sales at commencement, which produces a large day-one revenue figure and then nothing but interest. An operating lessor books rental income straight-line over the term.

And the income line changes character. Finance-lease income is interest, computed at a constant rate on a declining balance, so it front-loads. Operating-lease income is rent less depreciation, which is flat if both are straight-line.

Two smaller rules repay knowing. A lessor recognises operating lease income on a straight-line basis even where the payments are not level, unless another systematic basis better represents the pattern of benefit, So a rent-free period at the start of a nine-year retail lease still gets spread over the whole term.

And under US GAAP a lessor with an operating lease tests the underlying asset for impairment in the ordinary way, while a finance lessor tests the net investment for credit losses instead. Different model, different trigger.

The lessor's numbers, and the same aircraft from the other side

Three quantities define a finance lessor's position and the relationships between them are worth memorising.

The gross investment in the lease is the undiscounted sum of the lease payments receivable plus any unguaranteed residual value accruing to the lessor. The net investment is that same set of flows discounted at the rate implicit in the lease.

Unearned finance income is the difference between the two, and it is the interest the lessor will earn over the term.

The rate implicit in the lease is defined, and nobody gets to pick it. It's the rate at which the present value of the lease payments plus the unguaranteed residual equals the fair value of the underlying asset plus the lessor's initial direct costs. You solve for it, and it's rarely a round number. The lessee is told to use this rate when it's readily determinable. Lessees so often fall back on their incremental borrowing rate for one reason: they can't see the lessor's residual assumption.

How does a dealer or manufacturer lessor record the sale?

At commencement a manufacturer or dealer lessor makes three entries at once. It recognises revenue equal to the fair value of the asset, or the present value of the lease payments discounted at a market rate if that is lower. It recognises cost of sales equal to the carrying amount of the asset less the present value of the unguaranteed residual. And it derecognises the asset and puts up the net investment.

That third element is where authors go wrong. Hold on to the identity as you go. Deducting the present value of the unguaranteed residual from cost of sales, when the same present value has already been excluded from revenue, means the residual cancels. The selling profit is just the ordinary trading margin, fair value less carrying amount, and nothing else. Worked Example 1 shows it landing at ₹14,00,000 on a machine that cost ₹66,00,000 and sells for ₹80,00,000, with the residual assumption having no effect on it whatever. If your selling profit moves when you change the residual, you have made an error.

Thereafter the net investment runs on the effective-interest method you already know from the bond work. Opening balance times the implicit rate is interest income. The payment received reduces the balance. At the end of the term the closing balance equals the unguaranteed residual, which the lessor recovers when the asset comes back.

Worked example: an aircraft lease, finance vs operating

Take the aircraft from the other side of the contract. SkyBridge Air's A320neo was leased for six years at $10,000,000 a year, and you built the lessee's liability schedule using a six percent incremental borrowing rate. Assume the lessor priced the schedule to that same six percent, so the implicit rate and the borrowing rate coincide and the two schedules can be laid on top of each other. The lessor's net investment on day one is the same present value, $49,173,243.26, and its schedule is the mirror image of the lessee's.

The lessor's interest income of $2,950,394.60 in year one is the lessee's interest expense to the cent, and the closing balances match the liability balances in the lessee's own table. Total interest over six years is $10,826,756.74.

Suppose instead the contract had failed the classification tests and the same lessor had run it as an operating lease. It keeps the aircraft, carries it at $49,173,243.26 and depreciates it straight-line over the six-year term to nil, which is $8,195,540.54 a year, against rental income of $10,000,000. A real aircraft lessor would depreciate over a much longer economic life to a substantial residual. The six-year run-off here is chosen so that both routes consume the same asset and the totals can be compared.

Profit is a flat $1,804,459.46 a year. Over six years it totals $10,826,756.74. That's identical to the finance route, to the cent.

Everything else differs. Year-one income under the finance presentation is 1.6351 times the operating figure. The revenue line is zero in one case and $10,000,000 a year in the other, so asset turnover and every margin computed on revenue are incomparable. And the balance sheet carries a financial receivable in one case and an aircraft in the other, which changes what a credit analyst thinks the collateral is.