I’m just going through leases at the moment and I’m slightly confused by the CFAI when it states that an operating lease will show higher profits in early years.
Let’s take a 4 year lease that was initially agreed on 01/01/2014 worth $100,000 when the interest rate was 5%.
If it was categorised as on an operating lease the yearly lease payment would be $28,201 and this would be recorded as a income statement expense i.e.
Dr Lease Payment $28,201
Cr Cash $28,201
If it was recorded as a finance lease, however, depreciation of the asset would be $25,000/year and the lease payment would be $28,201. Both of these would be recorded in the income statement i.e.
Dr Depreciation Expense $25,000
Cr Accumulated Depreciation $25,000
Dr Lease Payment $28,201
Cr Cash $28,201
As a result, net profit would be higher under an operating lease. But why would this only be the case in the early years? Because the lease payment does not fall under the finance lease and the lessee also has to record depreciation, surely net profit under an operating lease will always be higher?
Well . . . you don’t debit something called “Lease Payment”. You debit Interest Expense and Lease Liability for, respectively, the interest and the principle portions of the lease payment.
I’ve had a quick look at the article and you say the same thing as the textbook:
“Although the total expense over the life of the lease is the same, the expenses for the finance lease will be higher than those for the operating lease in the early years, and lower in the later years. Thus, net income (and net margin) with a finance lease will be lower in the early years and higher in the later years.”
But there is no explanation as to WHY the expenses will be different in the early years as compared to later years. I’m really struggling to come up with a rationale for why these differences are only temporary and not permanent.
I encourage you to take more than a quick look. You’re incorrect about me saying the same thing as the textbook, and you’re incorrect about there being no explanation about why.
Perhaps your studies should amount to more than a quick look.