Financial Education

Recognizing when something has been sold is relatively straightforward. However, how about a situation in which something is being leased – for example, a company car. Should the lessor report the revenue they receive all at once as a sale or in installments as rental income? Should the lessee count the car as an asset on its balance sheet?

These issues can be important, as the accounting method chosen to record the lease has implications for the financial statements of both the lessor and the lessee. Generally speaking, the lessor will prefer to account for the transaction as a sales-type, or capital lease while the lessee will prefer to use an operating lease.

In a sales-type, or capital, lease the ownership of the asset shifts from the lessor to the lessee, just as it would in a regular sale. The lessor records sales revenue and no longer carries the asset on its balance sheet. The lessor records a capital expenditure on the cash flow statement, a liability reflecting the fact that the payment is being made in installments rather than all at once, and an asset on the balance sheet.

According to Financial Statement Analysis: A Global Perspective, the  both U.S. and International accounting standards require leases to be treated as capital leases when the lessee derives substantially all the economic benefits from the property, and as an operating lease when the lessee does not acquire substantially all of the economic benefits.

For more information, see all articles on: Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis

See also:

Why Do Companies Use Operating Leases?

Economic Value Added (EVA)

How Lessors Report Capital Leases Classified as Sales-Type Leases

How Lessors Report Capital Leases Classified as Direct Financing

How Lessors Report Operating Leases