Module 19.7 LOS 19.c: Restating a Balance Sheet for an Operating Lease

Normally, an operating lease is neither and asset or liability. Lessees only report rental expense on the income statement.

When analyzing financial statements however, an operating lease should be treated like a finance lease, which is accounted for like an asset purchase that is financed by debt, increasing assets and liabilities by the same amount. Capitalizing an operating lease will increase financial leverage.

On the income statement, it is necessary to replace the rental expense (payment) for the operating lease with depreciation expense (on the lease asset) and interest expense (on the lease liability).┬áIn the early years of a finance lease, depreciation expense and interest expense will exceed the lease payment. As a result, net income will be lower in the early years for a finance lease compared to an operating lease. In addition, by recognizing interest expense in the lessee’s income statement, the interest coverage ratio will likely decline (higher denominator).

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