Comparison between Capital Lease & Opearting Lease for lessor:

	Sales-type	Operating Lease
At inception
Profit	None	Yes
Assets	increase	no change
During Lease term
Profit	more earlier	more later
Total CF	same	same
CFO	less	more

Notes:
· CL: create asset, immediate income to shareholder’s equity => lower leverage ratio
· Total income over lease life same for both, i.e. recorded profit + interest revenue=sum (lease payment-depreciation)
· CL: gains from sales & interest income belongs to CFO, OL: all lease payments belongs to CFO

Impact between sales type lease and direct-financing lease
· Impact at inception of the lease:
· Direct-financing lease has no impact.
· Sales-type lease results in an increase in revenue, net income, current assets due to the gross profit booked upfront. It also increases CFO and decreases CFI.

Impact over the life of the lease:
· Direct-financing lease results in a relatively higher interest income {this includes gross profit from sale}, and relatively higher CFO and lower CFI than a sales-type lease.
· Net cash flows are same for both methods.

Sales-type Lease & Direct Financing Lease

Sales-type lease:
The lessor is also the producer or dealer who has sold the lease, ie include manufacturing & selling profit. In this case:

A sales-type lease is accounted for like a direct-financing lease, except that profit on a sale is recognized upon inception of the lease, in addition to the interest income recognized during the lease term. The gross profit recognized at the inception of the lease is the PV of all lease payments minus the cost of the leased asset.

At inception:
sales = PV of lease payments
COGS= (Cost of asset leased – PV of estimated salvage value)
Gross profit = (Selling price - Cost of the asset)

Note:
· The gross profit is recorded in income statement, +CFO, -CFI, no change in total CF

Asset: net investment in the lease = PV of future lease payments + estimated salvage value

During lease term:
Interest income: A part of the lease payment is booked as interest income affecting CFO; the rest is used to amortize the net value of the lease.

Interest income = Implicit interest rate x Net value of lease remaining},
Where: the implicit interest rate is the rate at which PV of MLPs = Selling price of asset.

End of each year:
Substract net investment in lease the difference between the lease payment AND the interest income, affecting CFI.

Direct-financing lease:
· The lessor is not the producer or dealer who sold the lease.
· No sale or gross profit is recognized at inception.
· The lease is recorded with reduction in inventory and increase in lease receivables.
· A part of lease payment is booked as interest income and the rest is used to reduce the lease receivable:

• Interest income = Implicit interest rate x Net value of lease remaining)
• The implicit interest rate is the rate at which PV of MLPs = Cost of asset.

Accounting for Leases by lessor

A lessor (the leasing company) can account for a lease in three ways:
1. Operating lease
2. Direct-financing lease
3. Sales-type lease
4. Lease capitalization, which includes the direct-financing lease and the sales-type lease, needs to be recognized when a lease meets any one of the four criteria specified for capitalization of leases and both of the following revenues-recognition criteria:

- Collection of the monthly lease payments is reasonably predictable.

- Lessor's performance is substantially complete, or future costs are reasonably predictable.

- If the lease is accounted for as a capital lease, the lessor must determine if it classifies as a direct-finance lease or as a sales-type lease.

• To classify as a sales-type lease, the fair value of the asset must be greater than the lessor's book value.
• If not, it is accounted for as a direct-financing lease.

Direct-Financing Lease

As its name implies, a direct-financing lease is basically the coupling of a sale and financing transaction. In this case, the lessor removes the leased asset from its books and replaces it with a receivable from the lessee.The only income recognized by the lessor is the interest received. The implied rate is taken by calculating IRR of the asset; cash inflow is equal to lease payments and cash outflow is equal to the book value of the lease asset.

Sales-Type Lease

Impact of Capital (versus Operating) lease for lessee on financial ratios

Item	Impact
CFO	Higher (more +ve) Part of lease payment shifted to CFF (under Operating Lease, all lease payment->CFO)
CFF	Lower (more -ve) Part of lease payment shifted to CFF
Net cash position	No impact CFO and CFF balance out
Assets	Higher Due to lease asset
Liabilities	Higher Due to lease liability
Equity	No impact
Depreciation	Higher Due to lease asset depreciation
Interest expense	Higher Due to lease liability
Net income	Lower Lower now, higher later
Profitability (ROA)	Lower Lower NI higher assets
Leverage (Debt/Equity)	Higher Higher liability, lower equity
Liquidity (Current ratio)	No impact No change in CR or CL
Asset turnover	Lower Due to higher assets
Operating income	higher as depreciation always lower than lease payment (reason: depreciation is only based on PV of all lease payment). Total income over the lease life is same for both as sum (lease payment)= sum(depreciation +interest expense). But in early years, as interest expense is higher than later years due to amortization loan, net income is lower for CL in early years.

Financial reporting from the lessor’s perspective:
· The lessor can take the lease asset off its balance if it meets one of the four criteria for capital lessee {see above}, and two further criteria:
· The Minimum Lease Payments (MLPs) are reasonably certain to be collected and
· No significant uncertainties exist regarding the reimbursement of costs incurred by the lessor under the lease contract. If these criteria are not met, the lessor must retain the underlying assets on its balance sheet. If they are met, the lease must be treated as salestype or direct financing type lease.

Impact of operating leases on financial statements

Balance sheet
· No assets or liabilities are recorded.

Income statement
· The operating-lease payment will be treated as an operating expense.

Cash flow statement
· CFO will include the total lease payment for the specified accounting period

Impact of capital leases on financial statements

Balance sheet
At the inception:
· Create an leasehold asset and leasehold liability equal to the PV of lease payments discounted using lower of the lessor’s implicit rate and the lessee’s marginal borrowing rate.

Going forward:
· the leased asset is depreciated with the lessee's usual policy for depreciating its operational assets 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
Lease payments are split into two parts:

1) interest expense
· included in the income statement but is not part of operating income (earnings before taxes from continuing operations)

Interest expense = leashold liability x discount rate

2) Principal repayment
· included in the income statement and operating income.

Difference between lease payment and interest expense = principle repayment

Note:
· The interest portion will be higher in the first few years of the lease.
· Total income over the life of the leased assets will be the same for operating lease and capital leases.

Cash flow statement
· Interest expense included in cash flow from opeartions (CFO)
· Principal repayment included in cash flow from financing activities (CFF)
· Depreciation included in CFO

Note:
· CFO includes only the interest portion of the capital-lease expense and thus is overstated.
· The principal repayment is included as a cash outflow from CFF and thus understates CFF.
· Total cash flow statements remain unaffected by operating and capital leases.

Lease Classification

A lessee should classify a lease transaction as a capital lease if it is non-cancelable and met one or more of the four classification criteria:
· Title/legal ownership of the asset passes to the lessee at the end of the lease
· The lessee has a bargain purchase option.
· The non-cancelable lease term is equal to or greater than 75% of the remaining life of the asset.
· The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset, by using the lower of lessee’s incremental borrowing rate or implicit interest rate. The implicit interest rate is the discount rate that make PV equal to fair market value.

If none of these criteria are met, the lease can be classified as an operating lease.

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.

Types of Off-Balance-Sheet Financing

Many economic transactions and events are not recognized in the financial statements because they do not qualify as accounting assets or transactions under GAAP standards. But these unreported assets and liabilities have real cash flow consequences.

Operating lease
Classifying a lease as an operating lease provides a company with the opportunity to utilize the leased asset and assume a contractual obligation to pay the lessor during a specific period of time without having to report the asset and the liability.

Impact:
· Reduces assets and liabilities. Boosts leverage (debt/equity), profitability (ROA), and Activity (Sales/Assets) ratios.

Take-or-pay contract
Buyer commits to purchase a minimum quantity of input over a specified time period. Buyer effectively receives the use of a productive asset without reporting it on its balance sheet. Disclosure rules require firms to report the minimum future payments.

To reflect economic reality of TOP contracts an analyst should add the PV of the minimum payments to both the assets and liabilities. This increases leverage and reduces asset turnover.

Throughput arrangements
Natural-gas companies use throughput arrangements with pipelines or processors to ensure distribution or processing. The effects are the same as take-or-pay contracts.

Commodity-linked bonds
Natural-resource companies may also finance inventory purchases through commodity-indexed debt where interest and/or principal repayments are a function of the price of the underling commodity.

The sale of accounts receivables
A company may sell its receivables to an unrelated third party to reduce its debt and improve its financial position. Most sales of receivables provide the buyer with a limited recourse to the seller. However, the recourse provision is generally well above the expected loss ratio on the receivables (allowance for doubtful accounts). The potential liability associated with the buyer-recourse provision is not displayed on the balance sheet.

Sale of receivables no-recourse basis:
· Truly removed from balance sheet.

Sale of receivables limited recourse basis:
· Firms recorded them by reducing AR and increasing CFO. The seller is exposed to the collecting risk and so economically they are just collateralized loans.

To reflect economic reality of sale of receivables limited recourse basis, an analyst should:
· Add back sold receivables to AR and create a current liability equal to the proceeds of sale.
· Subtract sold receivables from CFO and CFF.
· Increase revenues and interest expense by effective interest paid on the transaction.

These adjustments reduce the current ratio, increase the leverage and reduce the interest coverage.

Financing subsidiaries:
Not consolidated in parent company’s accounts if ownership is less than 50%. Firms often manipulate accounts by shifting their assets and liabilities out to subsidiaries

Analyst should add back proportionate share of the asset or liab for debt-to-equity ratio, receivable turnover, interest coverage ratio.

Joint ventures:
May create obligations for parent firms if any direct or indirect guarantees are given to secure financing.

Analyst should add guaranteed debt or proportionate non-guranteed share of debt