Question

In a financing lease, “front loading” of lease expense and lease revenue occurs. What does this mean, and how is it avoided in an operating lease?

 

 

Answer 1

In a finance lease, the lessee records more expense and the lessor records more revenue early in the life of the lease. This “front loading” of lease expense and revenue occurs due to the fact that interest is higher initially than it is in the later stages of a lease (constant interest rate times a declining lease balance), while amortization expense for the lessee’s right-of-use asset remains the same straight-line amount each period.

 

This “front loading” is avoided in an operating lease because both the lessee and lessor record total lease expense (lessee) and interest revenue (lessor) on a straight-line basis. The lessee records its total lease expense on a straight-line basis over the term of the lease. This is accomplished by recording interest the normal way (at the effective interest rate) and then “plugging” the right-of-use asset amortization at whatever amount is needed for interest plus amortization to equal the straight-line lease payment. The lessor, having recorded no entry affecting its balance sheet at the beginning of the lease, simply records lease payments as lease revenue on a straight-line basis.

In a finance lease, the lessee records more expense and the lessor records more revenue early in the life of the lease.