Finance vs. Operating Lease (Lessee’s Perspective) #Finance

in this CashNews.co we’re going to discuss the difference between a Finance lease and an operating lease from the perspective of the lesie so the main

theoretical difference between a Finance lease and an operating lease is that with a text-decoration: none;">Finance lease we’re saying that the less or has effectively transferred control or ownership of the property to the lesie and there’s five tests that we use to determine whether it should be a

style="font-weight: bold; color: #1a73e8; text-decoration: none;">Finance lease or an operating lease and I’ve made another CashNews.co on that so we’re not going to talk about that here instead I want to focus on the Accounting differences so if you had a

lease I want to show you how it would be different if you were to categorize it as Finance relative to operating okay so with a

style="font-weight: bold; color: #1a73e8; text-decoration: none;">Finance lease you’re going to have two different expenses that are recognized you’re going to recognize interest expense and amortization expense separately with an operating lease you’re just going to

have one expense and it’s going to be called lease expense however that’s a little misleading because this lease expense actually includes interest and amortization and in both cases we’re going to make an effective interest table and we’re going to be figuring what is the

interest that is effectively accured on the leas liability and so forth and we’re going to be amortizing the right of use asset that is recognized in each case so in some ways the none;">Finance lease and operating lease are very similar right we’re recognizing an asset we’re amortizing that asset over time we’re recognizing a lease liability we’re recognizing interest on that lease liability however there there is that

Accounting difference of saying well we’ve got interest expense amortization and then just lumping it together with lease expense for operating and the amounts can be different right so if you were to add the interest expense and amortization expense so you get the total

expenses associated with a a lease for a Finance lease in a given period is very likely to be different than the lease expense that you would have under an operating lease

and the reason is that lease expense under an operating lease is typically going to be the same amount each year okay so you’re basically you’re recognizing interest and interest it gets lower and lower each year as the least liability gets lower and lower because if you think about if

you have less of a liability you’re going to have less interest ACC crewing on that liability however the amortization is set up such a way it’s like an Accounting plug so that the lease expense is automatically the same each year and I’m going to show you that

with some journal entries and uh and then with a Finance lease typically the total expenses will be higher in the early years of the lease and the reason is that the lease

liability is higher in the in the early years and so you’re having higher interest right and then the amortization is just being done on a straight line basis and so it’s usually the same each year so we’re getting higher interest in the early years and you add that to the

amortization the total expenses will also be higher in the early years and then it’ll be lower the later and later you get in the lease term let me show you I’ll show you the effective interest table and which is exactly the same I’m going to give you an example here and if you

watch my CashNews.cos on the Finance lease and operating lease you’ve already seen this fact pattern it’s the same one I use in those CashNews.cos I just want to

give you a quick rundown your company’s going to lease a truck for three years the trucks expect to have a residual value of $155,000 at the end of the lease your company’s going to make lease payments $20,000 the beginning of each year so that’s going to be an annuity due

we’ll use the less ores implicit interest rate of 6% to figure the present value of the residual value the 15,000 is 12594 but more importantly the present value of the lease payments of that 20,000 a year for three years and starting the beginning of each year that annuity due is 56,600 uh

262 the fair value okay now the effective interest table we’re going to take the present the lease payments and then we’re going to have that that’s going to be our our least liability in the be beginning okay so that’s going to be our lease liability now we have we

recognize interest on a liability and then we have reductions in the liability each period now that is the same whether you’re using the whether it’s an operating lease or a none;">Finance lease but I want to show you how the journal entries will be different for each based on whether you classify it as as Finance or if you classify it as operating

and I’ve got the Finance leases on the left there’s all these journal entries on the left and then the operating leases on the right so you see that with each one

whether it’s Finance or operating we debit a right of use asset and Credit lease liability in the beginning for the same amount 56,600 that’s the same each way

right so we don’t we don’t change that however on December 31st the the end the year end of the very first year this is where things are different remember the operating we just have one lease expense account but we have interest expense and amortization expense separately for the

Finance lease that’s where things are different so the interest expense you’ll see is $2,200 uh for so that’s basically just the 36,6 68 times the less

or’s uh implicit interest rate of 06 that gives you 2200 so that 2200 is interest expense and then increases the lease liability for the Finance lease however with the

operating lease we still recognize that 2200 you see here we Credit lease liability for 2200 now we’re paying 20,000 and Lease uh $20,000 for our lease payment so we debit lease expense for 20,000 but then it’s like pretend you don’t know what the right of use

asset is well we say well we’ve got a Credit a lease liability of 2200 and a debit the lease expense of 20,000 we need a plug we need a plug to make this balance so 17,800 that’s how much the right of use asset is amortized but notice we don’t say amortization

expense we don’t say interest expense over here we just have lease expense so in a way it accounts for the interest just like we accounted for the interest with the none;">Finance lease but it just doesn’t have its own separate interest expense and the right use asset the amount that is amortized it’s just a plug to make us get to this 20,000 lease expense because we’re going to have 20,000 lease expense every year for the

operating lease okay now the Finance lease we’re going to have the same amortization expense each year okay we’re just we’re just dividing this 56 668

divided by three so we’re going to have the same interest uh amortization expense $1,889 however this Credit to right of use asset for the operating lease is going to be different each time because it’s a plug okay let me show you with the second uh the second year and

it’ll make it a little easier to understand again we reduce the lease liability in each case when we pay 20,000 to do the cash that’s not different whether it’s Finance or

operating lease so let’s go to the operating lease first over here so again now we’ve got that interest which was 1,132 okay so we take that and that now we’ve got our lease liability here is increasing because of that interest but we don’t have interest expense over here we

just debit lease expense that accounts for the interest and the amortization now the lease expense again is 20,000 it was 20,000 before and it’ll be 20,000 next year we do 20,000 every time for the operating method all right it’s the same lease expense and then we set this right of use

asset to be the plug all it is if we say okay we got 20,000 lease expense 1,132 lease liability to make this balance we have to amortise by1 18, 868 however so so by the way so you notice that’s different than what we had before before we had 17,800 now we have 18868 for the operating lease

method but the amortization for the Finance lease is the same each time right it’s 18,8 A9 18889 because we’re just amortizing this asset straight line for the

financing lease method okay so again we’re going to have interest expens will be separately recognized 1,132 and then we’ll have the amortization expense separately recognized okay and then when we get to the the final set of entries again we make a $20,000 payment so we’ve got

$20,000 and that that’s the same each way now we’re going to have for the final for the operating method and let me just make sure you can see here right and then the right hand side is the operating expense so that’s over here so we’ve or the operating lease method so

we’ve got lease expense again of 20,000 it was 20,000 every time see it was 20,000 every time and then we just amortised we don’t have any interest the final year because we made that payment on January 1st so between January 1st and December 31st we already paid off our lease so

we’re not going to acrew any interest on lease liability because we have no lease liability it went to zero okay so all we have is to finish amortising the right of use asset so we just Credit right of use asset and then we have the the lease expense so again this is just a

plug to make this balance now for we do the same amortization expense again this each time for the Finance lease 8,889 and again we don’t have any interest expense

because we paid off the lease liability on January 1st so that final year there is no lease liability to effectively acrw interest now if you’re wondering hey how do how does the interest stack or how do the total expenses stack up for each one so if we were to take the total expenses so

we’ve got we’ve got five over here we’ve got the the amortization expense we’ve got three three amortization expenses and then two interest expenses for the none;">Finance lease okay now if you were to add those up they add up and let me change colors here so they add up to $59,999 now just due to rounding it is basically $60,000 which is the same if you were to add up the lease expense right so our lease expense we have three times we

recognize $20,000 a leaks expense so it’s $60,000 it’s just off due to rounding by this dollar but basically you see that the total expenses that are recogniz if we disregard whether it’s called uh interest or amortization or lease what whatever expense the total expenses end up

being the same uh in each case however if we were to go to each year or or each each time period so we say like right here uh the Le the expens total expenses would be 21,889 if you were to add these two together and then now here we have $2,221 and then of course at the bottom we have 8,889

because we just it’s just this so and then we compare that to okay 20,000 20,000 and 20,000 we see that for the Finance if we were C categorize this lease as a

Finance lease then the total expenses very first year would be 2189 would be $1,089 higher than the operating lease uh method and then it’ be $2,021 versus $2,000 and

year two so in year two Finance would be a little bit higher basically the same right they’re just off by $21 and then in the third uh the third year then we see we have actually uh uh

less expense 8,889 under the Finance method and then the expense is greater under the operating lease method so BAS basically we’re getting the same expenses

we’re just classifying them differently as interest and amortization and and that it’s a timing difference and that with the Finance lease in the early periods

the the expense the total expenses are going to be higher than they would be uh under the operating lease method