What Are the Effects of a Lease in an Income Statement?

Accounting rules break leases into two classes. When you lease equipment or a building for a relatively short term, you have an operating lease, AccountingTools explains. If you lease long-term or in a lease-to-own arrangement, you have a capital or finance lease. Both classes affect the income statement and balance sheet but in slightly different ways.

Tip

Lease payments are an expense, and you report them as such on your company's income statements. You also report depreciation or amortization of the lease as an expense, combining the two items into one negative amount that you subtract from your company's gross income.

Capital and Operating Lease Example

If you pay to lease something from a vendor and then return it when you're done, you have an operating lease. A classic operating lease example is leasing for cars and trucks. Lease rather than buy and then return them when the lease expires. That way, you can maintain a fleet without worrying about the cost of repairs or disposing of and replacing the vehicles when they age.

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According to Business News Daily, you can take out an operating lease on a wide range of equipment to meet your needs for IT, manufacturing, construction and so on. Many small businesses go with this option because it's cheaper than buying. The down payment is often lower than if you bought, as are the monthly payments. A service agreement on leased equipment saves you from needing an in-house repair crew. It's also easier to return the equipment when it ages or when a newer model comes along.

The difference between operating and capital leases is in the terms of the deal. Say your company leases a backhoe. This might be another operating lease example, but if it meets any one of five conditions, it's a capital lease instead.

• You're leasing to own. The asset will transfer to your ownership at the end of the lease.
• You have an option to buy the asset at a discount when the lease ends.
• The lease lasts at least three-quarters of the asset's useful life. Useful life in this context is measured by accounting standards, not how long you actually use something.
• The present value of the lease payments is greater than 90 percent of the asset's fair market worth. There are standard accounting formulae for figuring out the present value of a lease stretching, for example, three years ahead.
• The equipment is so specialized, nobody else can use it.

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Operating and Finance Lease Accounting

The financial-standards board that oversees accounting rules has changed the way you record leases, Cohen & Co. warns. In the past, you reported expenses of both leases on the income statement and also recorded finance leases on the balance sheet. The new rules put operating expenses on the balance sheet too. The new rules apply to publicly traded companies currently and are expected to apply to privately held companies in the near future.

If you have an operating lease, you record the payments you make to the lessor as a lease expense on the income statement, along with amortization. The CPA Journal notes you report them as one item. Unlike with the old standards, you report the present value of the operating lease on the balance sheet. The right to use the equipment is an asset; the lease value is a liability.

A capital lease also affects the income statement. You report depreciation as well as interest on the lease principal. You also record the right to use and the lease value respectively as an asset and a liability on the balance sheet.

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