Liabilities - Effects Of Capital Vs. Operating Leases

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 rate
    The 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.

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.

Determining The Value Of The Lease And The Lease Asset
Related Articles
  1. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  2. Investing

    Asset Manager Ethics: Investment Process and Actions

    Managers, in developing their investment process, need to determine some “general rules” that make it meaningful. We offer six.
  3. Professionals

    Career Advice: Financial Analyst Vs. Investment Banker

    Read an in-depth comparison about working as a Financial Analyst vs. working as an Investment Banker, two highly prestigious business careers.
  4. Professionals

    Advisors: Which Certifications Are Essential?

    The right advisor credentials can make all the difference, but wading through some 100 certifications can be a challenge. Here's some help.
  5. Investing Basics

    Asset Manager Ethics: Valuation Is A Tricky Business

    Asset managers must accurately represent all of a clients assets in the client portfolio. This can be tricky for unique and hard-to-value assets.
  6. Personal Finance

    Top 10 Most Valuable Sports Teams in 2015

    Cleats, pads and profits: we take a look at the top 10 most valuable sports teams in the world.
  7. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  8. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  9. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  10. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  2. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  3. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  4. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  5. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  6. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!