Financial Impact Of Choice Of Lease Classification:
- There is higher total expense (interest plus depreciation) at the beginning of the lease period with a capital lease due to the higher interest payments but as the lease expires the operating lease will have a higher total expense.
- There are lower operating expenses with a capital lease since part of the expense is interest payment.
- Ratios, using a capital lease:
- Increases asset values resulting in lower asset turnover and return on assets.
- Leverage and liquidity ratios will be affected by the addition of current and noncurrent liabilities.
- The current ratio and working capital will be lower as a result of an increase in noncurrent liabilities.
- The debt-to-equity ratio will usually be higher since a capital lease adds current and long-term debt to the balance sheet.
- Total cash flow is unaffected by the lease classification. However with a capital lease both financing and operating cash flows are impacted, with an operating lease only operating cash flows are impacted. Therefore with a capital lease a lessee will report higher operating cash flows.
Analysts should make the appropriate adjustments to the financial statements to restate the impact of using operating leases rather than capital leases.
Sale and leaseback of assets refers to a firm selling an asset and then continuing to have the use of that asset through a leaseback arrangement. This can be an attractive way of raising funds for a company with a low credit rating.
Both U.S. and IAS GAAP require that the lessees, in the case of a capital lease, do not immediately recognize any gain on the sale but amortize the gain over the life of the lease. For operating leases the treatment is different under U.S. and IAS GAAP; under U.S. GAAP Amortization over the term of the lease is required, under IAS GAAP the gain can be recognized immediately.
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