Capital Leases Vs. Operating Leases

1
Capital Leases Vs. Operating Leases

• The two types of leases have VERY different
  effects on the balance sheet, income statement
  and statement of cash flows and thus can be used
  to manipulate the firms reported financial
  position.
• What are the effects?
• You should be able to identify whether a firm
  uses one or the other type of lease.
• You should be able to convert one type to the
  other to compare firms that use different types
  of financing and assess a true financial
  picture of the firm.

2
Types of Leases

• Operating Leases No transfer of the risks and
  benefits of ownership
• Capital Leases Transfer of the risks and
  benefits of ownership

3
Capital Lease Conditions

• A lease is a capital lease if it meets at least
  one of the following conditions
• Lease period is ? 75 of the assets useful life
• PV of the lease payments is ? 90 of the market
  value of the asset
• Bargain purchase option
• Transfer of ownership to lessee

4
Operating Leases

• No asset or liability
• if you didnt get the risks and benefits of
  ownership you shouldnt show a liability or
  asset.
• Rent expense reduces net income and is an
  operating cash outflow

5
Capital Leases

• Record an asset and a liability in the amount of
  the present value of the future lease payments
• You received the risks and benefits of the asset,
  so treat the transaction as if you financed the
  purchase with debt.
• Amortize the asset (NOT a cash outflow!)
• Show interest expense (operating cash outflow)
  and principal payments (financing cash outflow)
  on the liability

6
Converting Operating Leases to Capital Leases

• Why do this?
• Firms that use operating leases ultimately have
  the same
  usable resources and financial
  obligations as those using capital leases.
• The obligations should be shown!