Effect of Operating and Finance Leases on Lessee Financial Statements and Key Financial Ratios

As stated in IAS 17 : Leases, there are two classifications of lease transaction that applicable in the financial statements of the lessee : (1) Operating leases and (2) Finance leases.

Followings are the effect of operating and finance leases on lessee financial statements and key financial ratios which was taken from : International Financial Reporting Standards - A Practical Guide by Hennie van Greuning.

(1) Balance Sheet

Operating Lease - Non effect because no assets or liabilities are created under the operating method

Finance Lease - A leased asset (equipment) and a lease obligation are created when the lease is recorded. Over the life of the lease, both are written off, but the asset is usually written down faster, creating a net liability during the life of the lease

(2) Income Statement

Operating Lease – The lease payment is recorded as an expense. These payments are often constant over the life of the lease.

Finance Lease – Both interest expense and depreciation expense are created. In the early years of the lease, they combine to produce a higher expense than is reported under the operating method. However, over the life of the lease, the interest expense declines, causing the total expense trend to decline. This produces a positive trend in earnings. In the later years, earnings are higher under the finance lease method than under the operating method. Over the entire term of the lease, the total lease expenses are the same under both methods.

(3) Statement of Cash Flows

Operating Lease – The entire cash outflow paid on the lease is recorded as an operating cash outflow

Finance Lease – The cash outflow from the lease payments is allocated partly to an operating or financing cash outflow (interest expense) and partly to a financing cash outflow (repayment of the lease obligation principal). The depreciation of the leased asset is not a cash expense and, therefore, is not a cash flow item.

(4) Profit Margin

Operating Lease – Higher in the early years because the rental expense is normally less than the total expense reported under the finance lease method. However, in later years, it will be lower than under the finance lease method.

Finance Lease – Lower in the early years because the total reported expense under the finance lease method is normally higher than the lease payment. However, the profit margin will rend upward over time, so in the later years it will exceed that of the operating method.

(5) Asset Turnover

Operating Lease – Higher because there are no leased assets recorded under the operating method

Finance Lease – Lower because of the leased asset (equipment) that is created under the finance lease method. The ratio rises over time as the asset is depreciated.

(6) Current Ratio

Operating Lease – Higher because no short-term debt is added to the balance sheet by the operating method.

Finance Lease – Lower because the current portion of the lease obligation created under the finance lease method is a current liability. The current ratio falls farther over time as the current portion of the lease obligation rises.

(7) Debt to Equity Ratio

Operating Lease – Lower because the operating method creates no debt

Finance Lease – Higher because the finance lease method creates a lease obligation liability (which is higher than the leased asset in the early years). However, the debt-to-equity ratio decreases over time as the lease obligation decreases

(8) Return on Assets

Operating Lease – Higher in the early years because profits are higher and assets are lower

Finance Lease – Lower in the early years because earnings are lower and assets are higher. However, the return on asset ratio rises over time because the earnings trend is positive and the assets decline as they are depreciated.

(9) Return on Equity

Operating Lease – Higher in the early years because earnings are higher

Finance Lease – Lower in the early years because earnings are lower. However, the return on equity rises over time because of a positive earnings trend.

(10) Interest Coverage

Operating Lease – Higher because no interest expense occurs under the operating method

Finance Lease – Lower because interest expense is created by the finance lease method. However, the interest coverage ratio rises over time because the interest expense declines over time.