Effects of Assets Leases on Financial Statements and Ratios

Introduction

A lease is a contract between a lessor or owner of an asset, and a lessee, who is seeking to use the asset. In exchange for the right to the use of the assets, the lessee makes periodic lease payments to the lessor.

Leasing versus Purchasing Assets

• Leases can provide less costly financing, usually require little, if any, down payment, and are often at fixed interest rates.
• A negotiated lease contract may contain less restrictive provisions than other forms of borrowing.
• Leases can reduce the risks of obsolescence, residual value, and disposition to the lessee because the lessee does not have ownership of the asset.
• Leasing the asset may be less costly than owning the asset for the lessee.
• Leases have perceived financial and tax reporting advantages:
  • Certain types of leases are not reported as debt on the balance sheet. The items leased under these circumstances also do not appear as assets on the balance sheet. No interest expense or depreciation expense is therefore included in the income statement.
  • Financial reporting standards sometimes differ from reporting under tax regulations. As a result, a company may own an asset for tax purposes while not reflecting it in its financial statements.

Question 1

If a lease is not reported as debt on a company’s balance sheet, which of the following statements is most accurate?

A. The items that are leased will still appear as assets on the balance sheet.

B. Interest expense or depreciation expense will be included in the income statement.

C. The items that are leased will not appear as assets on the balance sheet. and no interest expense or depreciation expense will be included in the income statement.

Solution

The correct answer is C.

If a lease is not reported as debt on a company’s balance sheet, the items that are leased will also not appear as assets on the balance sheet. and no interest expense or depreciation expense will be included in the company’s income statement.

Question 2

Given two similar companies, A and B, Company A decides to purchase an asset whereas Company B decides to lease a similar asset. Taking the financial costs into consideration in the case of the purchased asset, Company B would most likely report:

A. Higher operating cash flow as compared to Company A.

B. Higher net income as compared to Company A.

C. None of the above.

Solution

The correct answer is C.

Option A is incorrect since leasing an asset would decrease operating cash flow, as the entire lease payment would be deducted from the operating cash flow. Purchasing an asset would not affect the operating cash flow, as the entire purchase payment would be deducted from the investing cash flow.

Option B is also incorrect because purchasing or leasing an asset has the same effect on the income statement.

Reading 28 LOS 28o:

Explain and evaluate how leasing rather than purchasing assets affects financial statements and ratios

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