Operating and finance leases

A lease is an agreement between the owner of the asset (the lessor) and the party wishing to use the asset (the lessee). There are 2 kinds of leases: operating and capital. The 2 leases are very different from each other and have different accounting treatments. Let us see how operating leases are recorded in the books of the lessee.

A company that gets into an operating lease does not record the asset and the corresponding debt in its balance sheet. The lessee records the lease expense in the income statement and under cash flow from operating activities section in the cash flow statement.

If a company enters into a capital lease, it records the asset (lease asset) and the corresponding debt (lease liability) in its balance sheet. Depreciation and interest expenses are recorded in the income statement. In the cash flow statement, the interest expense is treated as a cash flow from operating activities while amortization of the lease obligation is recorded under cash flows from financing activities.

Effect on financial ratios
Firms with operating leases report higher profitability (depreciation expense is not charged), interest coverage (interest expense is lower) and return on assets (the asset is not recorded while the income generated from using the asset is recorded) than firms with capital leases. However, capital leases allow companies to report higher operating cash flows since only the interest expense is treated as an operating cash flow.