Accounting and Reporting by the Lessee - FRA

Finance Lease:
• On balance sheet, lessee reports leased asset and related liability (lease payable).
   o The initial value of both the leased asset and the lease payable is the lower of the fair value of the leased asset or the PV of future lease payments.
• On the income statement, the lessee reports interest expense on the debt (lease liability) and the asset depreciation expense (if the asset depreciable).
   o Interest expense = lease liability at the beginning of the period × interest rate implicit in the lease
   o Interest rate used by the lessee is the lower of the lessee’s incremental borrowing rate and the lessor’s implicit rate.
• On the statement of cash flows, (under U.S. GAAP) only the portion of the lease payment relating to interest expense is reported as operating cash outflow; while the portion of lease payment that reduces lease liability is reported as financing cash outflow.
   o Under IFRS, interest expense can be reported as operating cash outflow and or financing cash outflow.

Operating Lease: 
• On the balance sheet, no asset or liability is recorded.
• On the income statement, the lessee reports rent expense which is equal to lease payment only.
• On the statement of cash flows, lessee reports full lease payment (rent expense) as an operating cash
outflow.

In summary, a company reporting a lease as an operating lease as compared to an identical company reporting  an identical lease as a finance lease will show:
• Higher profits in early years
• Higher return measures in early years
• Stronger solvency position (lower debt ratios)
• Lower operating cash flows
• Stronger activity ratios

NOTE: Total expense over the life of the lease will be identical for both operating and finance lease.