Effects Of Capital Vs. Operating Leases

CFA Level 1 - Liabilities

Capital Leases - Effects On:

• Balance sheet  - At the inception of a capital lease, the company leasing the equipment will record the equipment as an asset, and the company will also recognize a liability on the balance sheet, by an amount equal to the present value of the minimum lease payments.
  
  The discount rate used will be the lower of the following two rates:
  The lessor's (the rental company's) implied rateThe lessee incremental borrowing rate

Going forward, the leased asset is depreciated in a manner consistent with the lessee's usual policy for depreciating its operational assets. It can be over the term of the lease (most common) or over the asset's useful life, if ownership transfers or a bargain purchase option is present.

• Income statement - A capital-lease payment includes two components: one is the interest expense - which is included in the income statement but is not part of operating income (earnings before taxes from continuing operations) - and the second component is the principal payment, which is included in the income statement and operating income. The interest portion will be higher in the first few years of the lease, and is consistent with the interest expense of an amortized loan. Total income over the life of the leased assets will be the same for operating and capital leases.
• Cash flow statement - Total cash flow statements remain unaffected by operating and capital leases. That said, cash flow from operations will include only the interest portion of the capital-lease expense. The principal payment will be included as a cash outflow from cash flow from financing activities. As a result, capital leases will overstate CFO and understate CFF.

Operating Leases - Effects On:

• Balance sheet - No assets or liabilities are recorded.
• Income statement - The operating-lease payment will be treated as an operating expense.
• Cash flow statement - Cash flow from operations will include the total lease payment for the specified accounting period.

Comparison of Capital vs. Operating Leases
Let's compare the differences between both lease options through an example.


Option 1
Company Leasing has approached Company ABC to lease equipment from it for five years (non-cancelable lease). The annual payment would be $20,000. The discount rate implied in the lessor's implied rate is 6%. Company ABC has an incremental borrowing rate of 7%. After the five-year period, the asset will be transferred to the lessor, which it will sell for scrap.

Option 2

Company L&R has also approached Company ABC to rent equipment from it. Under the term of the rental agreement, Company ABC will rent the equipment from Company L&R for an annual fee of $20,000. This equipment has an estimated useful life of 10 years.

Classification
If Company ABC accepts Company Leasing's offer, the lease agreement has to be classified as a capital lease because the non-cancelable lease term is equal to 75% or more of the expected economic life of the asset. (At the end the five years, the equipment is sold for scrap).

The second option can be classified as an operating lease. 

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