Criteria for Capital Lease

A lease is an agreement for the purchase of assets whereby a person or company purchases assets through financing from another party which may be the manufacturer or direct owner of the asset or some financial institution such as a bank.

Lease is also a rent agreement whereby a person or company agrees to rent an asset for a certain period of time. The party renting or purchasing these assets is known as a lessee. The lease agreement with respect to a lessee is classified into two categories which are capital lease and operating lease.

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The rent agreement is usually known as operating lease whereas the purchase agreement is usually known as non-operating lease or capital lease. Though the purchase agreements are usually known as capital leases some other conditions have to be met for the lease to be classified as a capital lease. A lease can be classified as a capital lease if it is non-cancelable and meets one of the four following criteria:

1. At the end of a lease agreement the ownership of the leased asset is transferred effectively from the lessor to the lessee.
2. There may be a provision for a purchase of the leased asset by the lessee at a price lower than the market value of the asset at the end of the lease agreement.
3. The time duration of the lease agreement is greater than or equal to 75 percent of original life of the asset.
4. The present value of the total lease payments should be greater than or equal to 90 percent of the fair value of the asset (Brigham & Ehrhardt, 2001).

One of the criteria for classifying a lease is the factor of present value of lease payments. This calculation is based on the discounting rate of the company which is an estimate and not an actual rate. The rate is estimated based on the next period lease payments or the total lease payments either using a constant rate or a declining rate.

The present values calculated under the different assumptions may yield varying present values. As the present values calculated are based on assumptions and do not reflect the actual values it would be difficult to compare the present value of the minimum lease payments with the fair value of the asset (White, Sondhi, & Fried, 2002).

Operating Lease or Capital Lease

The classification of lease as operating or non-operating affects the long term liabilities and the shareholders’ equity of the firm. The difference in the liabilities and shareholders’ equity entails a difference in the debt/equity ratio of a firm. If the company classifies the lease as capital lease it would result in a lower net income than the income reported with operating lease.

The lease payments under operating lease are included in operating expenses and are not included in the liabilities section of the balance sheet. Operating lease is not shown on the balance sheet as a liability and results in a higher net income thus companies would prefer to classify the lease as an operating lease to reflect higher net income and a lower debt/equity ratio. If the company chooses to record the lease as capital lease the lease payments would reduce the amount of net income and the total amount of lease will be included in the noncurrent liabilities.

A decrease in net income would mean a decrease in retained earnings and eventually a lower shareholders’ equity with higher long-term debts which would increase the debt/equity ratio of the company. The companies would prefer to classify leases as operating leases to benefit from the higher net income and a lower debt/equity ratio (Damodaran, 2005).

References

1. Brigham, E., & Ehrhardt, M. (2001). Financial Management: Theory and Practice 11th Edition. Cincinnati: South-Western Educational Publishing.
2. Damodaran, A. (2005, February 2). Operating Versus Capital Leases. Retrieved July 7, 2009, from Pages.stern.nyu.edu: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AccPrimer/lease.htm
3. White, G. I., Sondhi, A. C., & Fried, D. (2002). The Analysis and Use of Financial Statements. New Jersey: John Wiley & Sons, Inc.

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