An alternative to purchasing assets is to lease them. Leases have advantages over outright purchases, but are treated for differently than purchases in terms of accounting. Usually, leased equipment can be financed very cheaply due to the nature of lessors, whom may enjoy benefits such as economies of scale on equipment, which incentivize them to purchase more and lease extra equipment rather than purchase less. For lessee, there are benefits as well, as leases of equipment can be off-balance sheet, meaning no extra depreciation or expenses are included in the income statement, as no extra asset appears in the balance sheet.
There are two main types of leases, operating leases and finance/capital leases. A capital/finance lease is essentially the purchase of an asset by a lessee, with the payments being financed by the lessor. An operating lease is similar to a conventional rental agreement. The IFRS has some general terms that define a capital lease, such as the asset transferring to the lessee by the end of the lease term. The US GAAP outlines 4 possible conditions based on a similar set of rational, any one of which is enough to categorize a lease as capital.
- Ownership of asset transferred to lessee by end of lease.
- The lease contains a bargain buy option for the asset.
- The lease term is 75% or more of the asset’s useful life.
- The value of lease payments is 90% or more of the fair value of the asset.
Effects on Balance Sheet, Income Statement and Cash Flow
The differences in accounting are due to operating leases not being reported as an asset. For a capital lease, the balance sheet would record an asset and a liability. Operating leases are simply recorded as a lease expense on the income statement. This means that ROA will be higher with an operating lease and no debt or debt covenants are created. However, this also means that companies will lose the ability to deduct depreciation from net income, potentially losing out on some tax relief. Having an operating lease on the income statement would also reduce operating income. For a capital lease, only the interest portion of the payments would reduce the operating cash flow. Overall though, a finance lease causes higher debt and expense levels.
Companies with operating leases tend to show higher profits and return measures in early years, and have better solvency ratios. Finance leases will allow for higher operating cash flows.
On the flip side, lessors record the same type of lease the lessee does, but under US GAAP there are two types of capital leases that a lessor can enter in:
- Direct-financing leases – when PV of lease payments = carrying value of asset, only profit is interest.
- Sales-type leases – when PV of lease payments > carrying value of asset, beyond interest.
When a lessor enters an operating lease, revenue is recorded as payments are made, and the leased asset remains the lessor’s balance sheet. For a capital lease, the lessor gains a lease receivable asset and derecognizes the asset. In a sales-type lease, the income statement would also reflect the profit on lease. Because of the income generating in a sales-type lease, the lessor would also have to reflect it as an inventory sale with an applicable costs of goods sold. The profit from the sale is recorded at lease inception, and interest revenue is spread over the lease life.