Hi, in the last three posts we covered tangible and intangible long-lived assets, depreciation methods for long-lived assets and impairment of long-lived assets. Today, we will cover leasing and its effect on financial statements and ratios.
A lease is an arrangement where the owner of the asset, called the lessor, allows the lessee to use the asset in return for periodic payments. Leases can be classified into two type; finance leases and operating leases. Finance lease is purchase of an asset financed by debt, while operating lease is a rental agreement.
Reporting by the lessee on financial statements
- Operating lease: At the inception of this type of leasing no asset or liability is reported on the balance sheet. During the lease period, rent expense is recognized on the income statement. (Click here to learn more about expense recognition). On the cash flow statement, the rent expense is recorded as an operating cash outflow.
- Finance lease: At inception of this type of leasing, asset and liability both are recorded at lower of present value of future lease payments or the fair value. During the lease period, depreciation expense and interest expense both are recognized on the income statement.
In the cash flow statement, the lease payment is attributed to interest expense and principal repayment. Principal repayment is calculated as lease payment – interest expense for the period. Under GAAP, interest expense is reported as operating outflow while principal repayment is reported as financing outflow. Under IFRS, interest expense can be reported as either an operating or a financing cash outflow.
Reporting by the lessor on the financial statements
- Financing lease: At the inception of the lease, the lessor will record a sale at the present value of future lease payments. He will recognize cost of goods sold at the carrying value of the asset. The difference between the sale value and the COGS will be the gross profit on the income statement. (Click here to learn more about the income statement)
If the lessor is not the manufacturer of the asset, but is simply financing its purchase, the gross profit at inception will be zero.
The asset is removed from the balance sheet and a lease receivable is recorded on the balance sheet equal to the present value of lease payments. As the payments are received, the principal portion of the payment reduces the lease receivable.
Interest income is also recognized on the income statement. Interest income is computed as lease receivable at the beginning of the period multiplied by the interest rate.
On the cash flow statement, interest income is reported as operating inflow and principal reduction is reported as investing inflow.
- Operating lease: The lessor recognizes the lease payment as rental income. The asset remains on the balance sheet and a depreciation expense is recognized against it over its useful life.
Effect of leasing on financial statements
Finance lease cause assets and liabilities to be higher than under operating lease. In the early years of the asset’s life net income is lower under finance lease as depreciation expense is higher. In the later years of the asset’s life the depreciation expense will be lower, thus causing the net income to be higher under finance lease than operating lease.
EBIT, on the income statement, is higher under finance lease as interest expense is not a part of EBIT. Under operating lease, EBIT will be lower as rent expense is a part of EBIT.
On the cash flow statement, operating cash flow will be higher under finance lease as only interest expense is recorded as operating outflow. As against this, under operating lease, the entire lease payment (principal + interest) is recorded as operating cash outflow.
Cash flow from financing will be lower under finance lease as principal repayment is reported as financing outflow. As against this, under operating lease nothing is recorded under financing cash flows.
Point to be noted here is that, total net income and total cash flow will be the same under both the methods over the total period of the lease.
Effect of leasing on financial ratios
Asset turnover, return on assets and return on equity ratios will be lower under finance lease than operating lease as the assets (denominator) are higher under finance lease.
Debt/assets and Debt/equity will be higher under finance lease than under operating lease.
That’s all from me guys…with this we come to the end of the ‘long-lived’ assets series…..from the next post we begin discussion on Income Taxes…stay tuned….
For solved examples please refer to the CFA Institute books or CFA study materials. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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