Capital And Operating Leases

CFA Level 1 - Liabilities

Lease Classification

Note: For clarity, the classification of a lease should be considered on an item by item basis and not grouped together. In addition, the classification should be determined at the time of the commitment or signing of the lease which may or may not coincide with the date that the lessee actually receives the physical asset.

A lessee (the company leasing equipment) should classify a lease transaction as a capital lease if it is non-cancelable and if one or more of the four classification criteria are met: 

• The agreement specifies that ownership of the asset transfers to the lessee.
• The agreement contains a bargain purchase option.
• The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset.
• The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset.

If none of these criteria are met, the lease can be classified as an operating lease.

Choosing Capital and Operating Leases
Most companies will want to classify their leases as operating leases because they can provide a company with the following:

• Tax incentive
  • The tax benefit of owning an asset (depreciation expense) can be exploited best by transferring it to a party that has a higher tax bracket.
  • A firm with a lower tax bracket will have incentives to classify a lease as an operating lease.
  • A firm with a higher tax bracket will be more likely to classify a lease as a capital lease.
•  Non-tax incentives  
        o If a lease is classified as an operating lease no assets or liabilities associated with the lease are recorded on the balance sheet. Since the company's asset base is reported lower the immediate benefit would be a higher ROA than it would display had it classified the lease as a capital lease requiring a higher asset base. It will also allow a company to display better solvency ratios such as debt-to-equity.
        o Operating leases create off-balance sheet financing because no liability is recorded on the balance sheet since no asset is recorded. The result is the company would display to its debt lenders better debt covenant ratios.
        o Some companies link management bonuses to specific ratios such as return on capital which creates even more incentives to lean towards operating classifications.

While there are significantly more incentives to classify leases as operating, there are a few benefits to using capitalization:

• The lease expenses would reduce net income, thus potentially reducing a company's income tax expense and rates.
• Operating cash flow will be higher under a capital lease because there is no operating lease expense.

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