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Principal distinctions between operating and financial leasing FAQ

Please, describe principal distinctions between operating and financial leasing, and specifics of accounting of these types of leases. Answering your question, its important to note, that the essence of leasing is that a lessee is capable of obtaining for mid-term usage and in exchange for lease payments some assets he needs and which he has ordered from the lessor. Worldwide practices offer a great variety of forms in which leasing relationship can be enforced; leasing products may vary (1) by the number of participants to a lease; (2) type of assets offered for leasing; (3) whether or not foreign subjects participate; (4) forms of leasing payments; (5) scope of responsibilities (servicing) towards leased asset; (6) terms of usage of the asset and associated terms of depreciation. Depending on (a) duration of leasing, (b) terms of depreciation of the leased asset and (c) who (lessor or lessee) appoints the supplier (seller) of the asset and its specification, the leasing theory and practice distinguish between financial and operational leasing. The latter, typically is equated with rent. Attributes, by which these two types of leasing differ are presented in the International Accounting Standard (IAS) 17 Leasing. This document offers the following logics underlying distinction between financial and operational leases (see flowchart below):

As for the specifics of accounting of operational and financial leasing, the following must be noted: National Accounting Standard 14 Rent [NAS 14] is a formal document called to regulate accounting of leases in Ukraine. Under NAS 14, leases are disclosed in accounting as follows: Lessee:

1) Accounting of financial leasing: Item received for financial leasing is disclosed in accounting simultaneously as asset and liability at the lower at the beginning of the lease term value (fair value of the asset or present value of the sum of minimal leasing payments).

Difference between minimal leasing payments and value of the asset under financial leasing which was originally disclosed by the lessee at the inception of the lease, shall be recognized his/her financial expense in both accounting and reporting only in the amount that refers to the reporting period.

Financial expenses will be distributed between reporting periods over the term of lease with application of the leasing interest on the outstanding liabilities as of the beginning of reporting period (unless a finance lease specifies leasing interest rate, lessee shall apply interest rate for possible loans of the lessor for determining present value of minimal leasing payments and distribution of financial expenses).

Cost borne by the lessee in connection to improvement of the asset under finance lease (upgrade, modification, finishing, re-adjustment, renovation), resulting in bigger economic benefits for future, than were originally expected from its usage, shall be disclosed as capital investment which shall be included in to the value of the asset under financial lease. Losses from reduced usefulness of assets under financial lease must be recognized by the lessee in the procedure provided for by the NAS 7 Fixed Assets.

Asset in financial leasing is depreciated by the lessee over the whole period of anticipated usage of the asset. The period of anticipated usage of the asset under financial leasing is the term of its useful life (if the contract provides for change of the assets ownership title to the lessee) or shorter period of the following two term of lease or term of useful life of the asset in financial leasing (if transfer of the ownership title to asset under financial lease at the end of lease term is not anticipated). The lessee shall determine method of depreciation of the fixed asset under financial lease according to NAS 7 Fixed Assets and NAS 8 Intangible assets.

2) Accounting of operational lease: Lessee shall disclosed asset in operating lease on an off-the-balance account at the price specified in the rent agreement. Costs borne by the lessee in connection to improvement of the asset in operating lease (upgrade, modification, finishing, re-adjustment, renovation), resulting in bigger economic benefits for future, than were originally expected from its usage, shall be disclosed as capital investment in creation (construction) of other fixed material assets.

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