Differences between Operating lease and Finance lease

Below is some info I have prepared while preparing for Level-1 CFA exam. Hope it helps you.
Lessee perspective Lessor perspective
Expense Expense over life time is same both.
Reporting Operating Lease: Rent expense
recognized in income statement. CFO
affected
Operating Lease: Lease payment
recognized as Rental income.
Asset is kept on B/S and depreciated
over its life.
Financial Lease: B/S effected. Over
the term leased asset is depreciated.
Payment split into interest (Goes into
CFO) and principal (Goes into CFF)
Interest may go into CFF also if IFRS
Financial Lease: Treated as either sales
type lease or direct financing lease
Sales type(PV>CV) Treated as if asset
is sold and loan is provided to buyer
with same amount. Asset removed in
beginning from B/S and lease
receivable is created equal to the
PV. Gross profit is recognized between
PV and CV
Direct financing(PV=CV): No gross
profit recognized. Implies lessor simply
financing asset. Here it implies as
iflessor has bought asset from a third
party. Asset removed in beginning from
B/S and lease receivable is createdequal
to the same amount.
For both types, Principal is treated as
CFI and interest portion as CFO




Finance Lease

Operating lease

Assets

Higher

Lower

Liabilities

Higher

Lower

Net income(in early
years)

Lower

Higher

Net income(later years)

Higher

Lower

Total Net income

Same

Same

EBIT(o/p income)

Higher

Lower

CFO

Higher (because depreciation
not considered in CFO).because only
interest payments come here

Lower

CFF

Lower

Higher

Total Cash Flow

Same

Same.

CR (CA/CL)

Lower

Higher

Working capital (CA-
CL)

Lower

Higher

Asset turnover (NI/TA)

Lower

Higher

Return on assets

Lower

Higher

D/E

Higher

Lower

D/A

Higher

Lower

Both in o/p and finance lease firms should disclose payments for the next 5 years seperately and
cumulative amount of the next 5 years after that.

In exam, check for these where you might make mistakes

1. Check whether the payment is in beginning or the end of period while calculating leases. (This is
same for TVM problems too). You do not need to discount the first payment if it is in the beginning of
the period.
2. Check the duration to determine if the lease is operating or finance lease
3. In lease or bonds, we assume that we receive the interest rate on the amount issued at market
rate. Hence it is the netter of interest rate we receive and the coupon amount we pay