Operating and Financial Leases (Capital Leases)

Within an accounting context, a lease can be classified as an operating lease or a financial lease.

Operating lease (service lease) refers to a short-term lease of an asset with a useful life longer than the term of the lease. For example, this applies when fixed assets with a useful life of 15 years are leased for 3 years. This type of lease is common for fixed assets with a longer useful life but which become less efficient and even technologically obsolete relatively fast, such as computer systems and office equipment.

Operating leases usually can be cancelled but generally a cancellation penalty will apply. They also usually include maintenance clauses which require the lessor to conduct maintenance of the asset as well as tax and insurance payments.

Operational leases usually include a renewal option since the economic life of the asset is generally relatively longer than the lease term. This allows the lessee to renew the lease of the asset at the end of the term of the lease. A purchase option may be included at the end of the lease which will allow the lessee to acquire the asset.

Under an operating lease, a lessor transfers to lessee only the right to use the asset. The lessee does not have any level of ownership over the asset. Under an operating lease, periodic payments, as per the lease agreement, are recorded as expenses in the income statement. Operating lease expense is not recorded in the balance sheet.

Consequently, under an operating lease (compared to capital lease), financial ratios present misleading results. For example, leverage ratios are understated because no liability is recorded associated with the lease. For example, the debt-equity ratio is lower and so is the debt ratio. The times interest earned ratio is higher because under an operating lease, depreciation is not recorded.

Liquidity ratios are also affected. Both, the current ratio and quick (Acid-Test) ratio are overstated because the lease is not reflected in current liabilities. Moreover, the ROA profitability ratio is overstated because total assets are not affected under an operating lease.

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A lease is a contract between tenant (a lessee) and owner (a lessor) of the asset which allows the tenant to use owner’s property over specified period of time in exchange for periodic payments which the lessee makes to lessor. The contract must be signed by both lessee and lessor and is usually called a lease agreement.

Leases can be arranged for both tangible and intangible assets. Lease of tangible assets is lease of assets that one can see and touch and includes assets such as automobiles, buildings and equipment. Lease of intangible assets is a lease of assets that one cannot see and touch. An example will be a lease of use of a radio frequency.

Leasing is a substitute for purchase of a fixed asset. It is one of the ways in which an organization can finance its assets. It allows the firm to make use of an asset in exchange for contractual periodic payments which are tax deductible.