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101 Concepts for the Level I Exam

Concept 54: Finance and Operating Leases


Lessor (entity lending the asset) perspective

Operating lease

  • The asset remains on the balance sheet and is depreciated.
  • The lease payments are recorded as rental income.

Finance lease

  • The asset is removed from the balance sheet and replaced with a lease receivable.
  • The interest portion of the lease payment is recorded as interest income and the principal repayment portion decreases the lease receivable on the balance sheet.

Lessee (entity using the asset) perspective

Operating lease

  • No asset or liability is recorded on the balance sheet.
  • The entire lease payment is reported as a rental expense on the income statement and as an operating cash flow.

Finance lease

  • The leased asset is recorded on the balance sheet and depreciated over its useful life. The present value of the lease payment is recorded as a liability and amortized over the term of the lease.
  • The interest portion of the lease payment and the depreciation of the asset are recorded as expenses on the income statement.
  • The interest portion of the lease payment is recorded as an operating cash outflow and the principal portion is recorded as a financing cash outflow.

Compared to an operating lease, a finance lease will result in less profit for the lessee in the early years of the lease and greater profits in the later years.