Accounting

Effects of Leases on Selected Financial Reporting Items for Lessees

The table below summarizes the effects of operating and capital leases on selected financial reporting items for lessees.

ITEMOPERATING LEASECAPITAL LEASE
Balance SheetNo impact.Leased asset and lease liability are created.
Income StatementRent expense occurs over the life of the least; this may be a constant value.Interest and depreciation expenses are recognized. In the initial years expenses will be higher than an operating lease, but over the full lease term the two lease types have the name total effect.
Cash FlowsTotal change in cash is the same, but the full rent expense is treated as an operating cash flow.Total change in cash is the same, but the lease payment is divided between an interest component (an operating cash flow) and a principal repayment (a financing cash flow). The amount assigned to deprecation is a non-cash charge.
Profit MarginHigher in the early years, but lower in the later years, as compared to a capital lease.Lower in the early years because the total expense associated with the lease is higher than the actual payment, but profit margin will climb in later years of the capital lease.
Asset Turnover RatiosHigher because the operating lease records no balance sheet assets.Lower because a balance sheet asset is recorded, but the ratio will rise over time as the asset is depreciated.
Debt-to-Equity RatioLower because there is no liability recorded on the balance sheet for an operating lease.Higher because a lease obligation liability is recorded on the balance sheet, but the ratio will decline over time as the lease is repaid.
ROA & ROEHigher in the early years because assets are lower and earnings are higher.Lower in the early years because earnings are lower and assets are higher.
Interest Coverage RatiosHigher because a firm incurs no interest expense from an operating lease.Lower because a firm allocates a portion of the lease expense to interest.

A company may prefer to account for leases as operating leases when:

  • Management is partially compensated based on return on assets.
  • A firm wants to keep debt-like liabilities off its balance sheet.

A company may prefer to account for leases as capital leases when it wants to show a higher cash flow from operations.

Finance Train Subscription

Unlock full access to Finance Train and see the entire library of member-only content and resources.