Liabilities - Determining The Value Of The Lease And The Lease Asset
The discount rate used will be 6% because it is the lesser of the lessor's implied rate and the lessee's incremental borrowing rate.
1) Balance Sheet Effect:
|Year||Beginning Lease Value (1)||
Interest Expense (2)
|Lease Payment (4)||
Ending Lease value (liability)
|Depreciation||Book Value Of The Asset (fixed assets)|
Under the capital-lease method the asset will only equal the lease liability at initiation and at the end of the lease. In this example, the asset was depreciated using the straight-line depreciation method, or $16,849 ($84,247/5).
- On the other hand, the lease obligation is reduced by the principal-repayment amount during each specified accounting period.
- This interest component is determined by multiplying the beginning-period lease value with the discount rate used in the determination of the PV of the lease obligation.
- Since the lease obligation decreases with time, it is highest in the first year and declines over time.
- That said, the principal repayment on the lease liability is determined by subtracting the interest component for the specified period with the actual lease payment to the lessor.
- As a result, the principal-repayment amount increases with time and is lowest in the first year.
At the end of the lease, both the lease obligation will be eliminated and so will the asset value.
2) Income Statement Effect:
Under a capital lease, operating expenses include the depreciable portion of the leased asset, and the interest portion is classified as a non-operating expense and is included in earnings before tax.
- As noted earlier, the interest expense that emerges from capital leases is highest in the first years and decreases over time (unlike depreciation expense, which is constant).
- This creates a variation in a company's reported total expenses. In the earlier years, a company using a capital lease will report a lower net income than a company using an operating lease.
- This will also create a tax benefit for the company that uses a capital lease in the first years.
- This tax benefit will cancel out because in the later years, the interest component will decrease and reported income will increase.
3) Cash Flow Statement Impact:
Cash flow statements remain unaffected by the choice of classifying leases as operating or capital leases. That said, cash flow from operations will include only the interest portion of the capital-lease obligation. The principal repayment on the lease obligation payment will be included as a cash outflow from cash flow from financing activities. As a result, capital leases will overstate CFO by the amount included in CFF and understate CFF.
Summary of Financial Effects:
Impacts on Key Financial Ratios:
Career Education & ResourcesLearn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
ProfessionalsA financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
Career Education & ResourcesRead about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
Career Education & ResourcesLearn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
Career Education & ResourcesThe non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
Career Education & ResourcesLearn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
Your PracticeThese four professional organizations are among the most respected and well known in the industry.
ProfessionalsFind out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
ProfessionalsThe Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
ProfessionalsLearn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
Professionals who help individuals manage their finances by providing ...
Formerly known as the Association for Investment Management and ...
A professional designation given by the CFA Institute (formerly ...
A financial professional who studies various industries and companies, ...
While the majority of financial advisors work for financial institutions such as banks, a large proportion of them are self-employed ... Read Full Answer >>
If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>
Financial sampling allows auditors to approximate the rate of error within financial statements. For accounting purposes, ... Read Full Answer >>
The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>