Certified Management Accountant Practice Exam

To qualify as off-balance sheet financing, leases must be classified as operating leases. This distinction is important because operating leases do not appear on the lessee's balance sheet as liabilities, while finance leases (or capital leases) do. Under this classification, the rental expense is reported on the income statement, but the leased asset and corresponding liability are not included in the balance sheet totals.

Operating leases typically provide more flexibility and might be favored by companies looking to manage their financial ratios and leverage more effectively. They can circumvent the impact on asset management and debt ratios that comes from recording a finance lease, where companies must recognize the present value of lease payments as both an asset and a liability on their balance sheet.

While other types of leases, like finance leases and sales-type leases, fall under different accounting standards that treat them as capital leases and require them to be recorded on the balance sheet, operating leases maintain the off-balance sheet treatment until accounting standards change, which, in several jurisdictions, have evolved to minimize this classification over time. However, in traditional assessments, it is recognized that operating leases offer this off-balance sheet benefit.