Effect of Finance Leases and Operating Leases on Financial Statements

Introduction

In substance, a finance (or capital) lease is equivalent to the purchase of an asset by a buyer (or lessee) that is directly financed by the seller (or lessor).

An operating lease is an agreement providing the lessee with the use of an asset for a period of time.

Under IFRS, if substantially all of the risks and rewards incidental to ownership are transferred to the lessee, the lease is classified as a finance lease and the lessee reports a leased asset and a lease obligation on the balance sheet. Otherwise, the lease will be reported as an operating lease.

Impact on Financial Statements

Lessee Perspective

A company that enters into a finance lease as the lessee reports an asset (leased asset) and related debt (lease payable) on the balance sheet. The initial value of both the leased asset and the lease payable is the lower of the fair value of the leased asset or the present value of any future lease payments. The company will report interest expense on the debt on its income statement, and will also report depreciation expense if the acquired asset is depreciable.

In the case of an operating lease, the lessee will record a lease expense on its income statement during the period it uses the asset. No asset or liability will be recorded on the balance sheet.

The primary accounting differences between a finance lease and an operating lease are that under a finance lease, reported amounts of debt and assets are higher and expenses are generally higher in the early years. As a result, when a lessee reports a lease as an operating lease rather than a finance lease, it usually appears to be more profitable in the earlier years of the lease and less so later. Lessees, therefore, tend to prefer operating leases to finance leases.

For an operating lease, the full lease payment is shown as an operating cash outflow on the lessee’s statement of cash flows. In the case of a finance lease, however, only the portion of the lease payment relating to interest expense potentially reduces operating cash flows, while the portion of the lease payment which reduces the lease liability appears as a cash outflow in the cash flow from financing section.

A company reporting an operating lease will not only show higher profits in early years, it will also show higher return measures (such as ROA) in early years, a stronger solvency position, and appears less leveraged over the entire lease period than an identical company reporting an identical lease as a finance lease. The company reporting the finance lease will, however, show higher operating cash flows due to the fact that a portion of the lease payment will be reflected as a financing cash outflow rather than an operating cash outflow.

Lessor Perspective

If a lessor enters into an operating lease, it will record any lease revenue when earned. The lessor will also continue to report the leased asset on the balance sheet and the asset’s associated depreciation expense on the income statement.

In the case of a finance lease, the lessor reports a lease receivable based on the present value of future lease payments, and the lessor also reduces its assets by the carrying amount of the asset leased. The income statement will reflect interest revenue on the lease.

When a lessor reports a lease as a finance lease rather than an operating lease, it usually appears more profitable in the earlier years of the lease.

Question 1

Which of the following statements is least accurate?

A. In operating leases, the lessee records a lease expense on its income statement during the period it uses the asset.

B. A lessee reporting a lease as an operating lease rather than a finance lease will appear to be less profitable in the earlier years of the lease

C. A lessor reporting a lease as a finance lease rather than an operating lease will appear more profitable in the earlier years of the lease.

Solution

The correct answer is B.

A lessee reporting a lease as an operating lease rather than a finance lease will appear to be more (not less) profitable in the earlier years of the lease.

Question 2

For a lessor, reporting a finance lease instead of an operating lease would:

A. Increase net income in the early years of lease.

B. Increase cash flow from investing activities.

C. Both A & B.

Solution

The correct answer is C.

A finance lease would increase the lessor’s net income in the early years because all the revenue would be recognized in the first year of the lease contract versus dividing the lease revenue by the number of years in the lease contract in case of an operating lease. In addition, a finance lease would increase cash flow from investing activities as all the cash inflows from the lease would be considered as inflows from a financing contract. On the other hand, cash inflows in an operating lease would be considered as operating cash inflows.

Reading 28 LOS 28p:

Explain and evaluate how finance leases and operating leases affect financial statements and ratios from the perspective of both the lessor and the lessee

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