Capital Lease vs. Operating Lease

Lessee:
Firm leasing the asset for its use. Makes the lease payments.

Lessor:
Firm leasing out the asset. Receives the lease payments.

Capital lease:
· Benefits of ownership and risk rest with lessee.
· Equivalent to borrowing money and buying the asset. Lessee treat as purchase of property and thus record asset & LT Liability in balance sheet.

Operating lease:
· Lessor retains beneficial ownership of the asset.
· No obligaton appears in lessee’s B/S and no receivable appears in Lessor’s B/S. Rental payment recognised as expense for lessee & as income for lessor.
· Disclosure of cash payment and income for next 5 years in notes of F/S

Incentive for choosing operating leases
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.

Non-tax incentives
· No asset and liability recorded on the balance sheet allow a company to display a higher return on assets and better solvency ratios such as debt-to-equity.
· Off-balance sheet financing because the operating lease classification keeps the liability off the balance sheet. Since no liability is recognized, the company would display to its debt lenders better debt covenant ratios.
· Some companies link management bonuses to specific ratios such as return on capital. Higher if a lease is classified as an operating lease.
· If the leased asset is going to be used for a short period of time and/or the lessee feels that the equipment may experience a large decrease in value over time, the lessee will want to structure it as an operating lease.

Incentive for choosing capital leases
· A firm with a higher tax bracket will be more likely to classify a lease as a capital lease.
· a company will may benefit from a tax saving due to higher total lease expense in the early years.
· Operating cash flow will be higher under a capital lease.