**WHAT A LEASE IS AND THE TWO TYPOLOGIES**

The Lease is a contract between an owner (“Lessor”) of an asset and a renter (“Lessee”).

This contract gives the Lessee the right to use the property of that asset for a specific period of time.

In US GAAP there is a distinction between a FINANCE (or CAPITAL) LEASE and an OPERATING LEASE.

In IFRS every lease if a FINANCE lease.

In both the typologies, FINANCE and OPERATING, we have to capitalize the asset and create a corresponding liability on the balance sheet, because this kind of contract gives the Lessee the “right to control”, which means the right to obtain the economic benefits and direct the use of the asset.

**HOW TO DEFINE THE TYPE OF LEASE**

To recognize a Lease as a FINANCE rather than an OPERATING one, we have to remember that a FINANCE or CAPITALE LEASE is a Lease that has at least one of the following conditions:

1. There is a transfer of ownership after the end of the contract;

2. There is a purchase option at the end of the contract;

3. The duration of the contract involves the major part of the residual economic life of the asset (indicatively 75% or more);

4. The Present Value of the asset is higher than 90% of the Fair Value;

5. It’s not an asset with a specialized nature that has not alternative use to the Lessor at the end of the contract.

**ACCOUNTING METHOD FOR A FINANCE LEASE**

After having categorized the type of Lease, we have to consider the specific way to recognize the use of this asset in accounting.

If it’s a FINANCE LEASE, there are 2 expenses: one is the INTEREST EXPENSE (calculated as a percentage of the residual liability value) and the AMORTIZAZION expense, calculated with the straight-line method, so it’s constant year after year and it reduces the value of the asset.

Accounting from the Lessee’s perspective, in case of FINANCIAL LEASE, involves the following steps:

1. At the beginning of the period we have to recognize the value of the asset and the liability (the same) calculating the PRESENT VALUE of all the payments that will be made in the future (the PRESENT VALUE of ALL the FUTURE CASH OUTFLOWS for the contract).

For example, if we have:

· A 5-year lease

· A 20k payment (cash out) every end of the year

· The implicit rate is 6%

· No other initial direct/una tantum costs

We compute the present value of every payment for the next 5 year. In excel you can use the formula of the Present Value (for an “annuity”), which is in this case =PV(0,06;5;20000) (the value coming out of the Excel computation is negative: if you want it positive, you have to put the sign – in front of the 20000 value in the formula).

The PRESENT VALUE in this case is 84,247, which is an asset (“Right Of Use Asset”) and a liability (“Lease Liability”) in the balance sheet.

2. Subsequently, the asset must be amortized and the interest expense must be recorded.

For the amortization, at the end of the year we calculate, with the straight-line method, the Amortization expense (in this case 84,247 / 5 years = 16,849,40): so this same value should be recorded at the end of each year.

3. Always at the end of the year, the interest expense is calculated multiplying the (implicit) rate for the residual value of the liability. So, at the end of the first year, the computation is 6% * 84,247 = 5.055. This value is recorded as the interest expense of the first year, as a cost for the income statement.

4. To calculate the corresponding value of the liability that we have to credit (to reduce this value), we have to compute the difference between the cash outflows and the interest expense (20.000 – 5.055 = 14,945): so at the end of the first year the Lease Liability value is 69,302.

**ACCOUNTING METHOD FOR AN OPERATING LEASE**

In case of OPERATING LEASE, there is one EXPENSE and it’s constant (the value is the same) over the years. This only and constant expense consists implicitly in the sum of the interest expense, which decreases over the years, and the amortization expense, which increases over the years. Then the sum of interest expense and the amortization expense (the LEASE EXPENSE), even though they individually vary year after year, is the same for every year.

For example, if we have:

· 5-year operating lease

· Annual payment of 20.000

· Implicit rate of 7%

1. At the beginning of year 1 we calculate the Present Value of the future payments, which in this case is 82,003.95, and record it either as an asset (Right Of Use Asset) and a liability (Lease Liability).

2. At the end of year 1 we have interest expense of 7% * 82,003.95 (the value of the liability) = 5,740.27, while the amortization is the difference between the constant payment (20.000) and the interest expense = 14,259.72, but there is only one Lease Expense that is equal to the cash going out (20.000); then we credit 14,259.72 on the asset and debit 14,259.72 on the liability, so they both decrease to the residual value at the end of year 1 of 67,744.23.

3. At the end of year 2 we have interest expense of 7% of 67,744.23 = 4,742.10 and Amortization of 20.000 – 4,742.10 = 15,257.90, but there is only one Lease Expense that is equal to the cash going out (20.000); then we credit 15,257.90 on the asset and debit 15,257.90 on the liability, so they both decrease to the residual value at the end of year 2 of 52,486.33.

4. At the end of year 3 we have interest expense of 7% of 52,486.33 = 3,674.04 and Amortization of 20.000 – 3,674.04 = 16,325.96, but there is only one Lease Expense that is equal to the cash going out (20.000); then we credit 16,325.96 on the asset and debit 16,325.96 on the liability, so they both decrease to the residual value at the end of year 3 of 36,160.37.

5. At the end of year 4 we have interest expense of 7% of 36,160.37 = 2,531.23 and Amortization of 20.000 – 2,531.23 = 17,468.77, but there is only one Lease Expense that is equal to the cash going out (20.000); then we credit 17,468.77 on the asset and debit 17,468.77 on the liability, so they both decrease to the residual value at the end of year 4 of 18,691.60.

6. At the end of year 5 we have interest expense of 7% of 18,691.60 = 1,308.40 and Amortization of 20.000 – 1,308.40 = 18,691.60, but there is only one Lease Expense that is equal to the cash going out (20.000); then we credit 18,691.60 on the asset and debit 18,691.60 on the liability, so they both decrease to a residual value at the end of year 5 that is of course 0.

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