Financial Lease (Capital Lease)

Finance lease (also called financial lease or capital lease) refers to the lease of the asset where the useful life is closely aligned to the term of the lease. The lease term is longer than operating lease. Finance leases are usually leases for an asset which does not become technologically obsolete. Under a capital lease, the lessee is usually responsible for all maintenance and other costs. Comparatively, under an operational lease, lessor is usually responsible for such costs.

A lessor purchases an asset selected by the lessee. The lessee will be able to use the asset during the duration of the lease agreement as long as contractual, periodic and timely payments are made by lessee to the lessor.

At the end of the term, the lessee may have a purchase option which allows the lessee to acquire an ownership of the asset. The lessee is not allowed to cancel the lease which makes a financial lease similar to long-term debt. If a lessee misses contractual or periodic payments, the lessee may be forced into bankruptcy.

Because under a finance lease, the lessee may have some ownership of the asset with some risks and benefits that comes with ownership, a finance lease must be recorded as a capitalized lease. This refers to recording the present value of all contractual payments and assets and corresponding liabilities on the balance sheet.

Under a finance lease, the firm benefits from the tax-deductibility of the interest paid on the leased asset as well as from depreciation of the leased asset which is recorded as an expense on the firm’s income statement.

This leads to increases in the debt/equity ratio and therefore an increase in financial leverage compared to an operational lease. It also leads to a decrease in working capital due to an increase in current liabilities.

Moreover, part of the payments due to a financial lease are recorded as a reduction in lease liability under operating cash flows and part is recorded as lease interest payments under financing cash flows. This leads to an increase in operating cash flow compared to records under operating lease where only operating cash flow is affected.

Because firms have an incentive to report leases as operational leases, certain regulatory rules were established by Financial Accounting Standards Board (FASB) which specify which assets can qualify for operational leases. The following is a list of characteristics of financial leases. If even one of such characteristic is met than an asset should be recorded as financial lease.

  • A lease term is 75% or more of the useable life of the asset.
  • At the commencement of the lease agreement, the present value of the lease payments is equal to 90% or more of the fair market value of the leased asset.
  • Ownership of the asset is transferred to the lessee at the maturity of the lease agreement.
  • A lease agreement contains an option to purchase the asset at the “bargain price” which must be the fair market value.

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Operating and Financial Leases (Capital Leases)

Within an accounting context, a lease can be classified as an operating lease or a financial lease.

Operating lease (service lease) refers to a short-term lease of an asset with a useful life longer than the term of the lease. For example, this applies when fixed assets with a useful life of 15 years are leased for 3 years. This type of lease is common for fixed assets with a longer useful life but which become less efficient and even technologically obsolete relatively fast, such as computer systems and office equipment.

Operating leases usually can be cancelled but generally a cancellation penalty will apply. They also usually include maintenance clauses which require the lessor to conduct maintenance of the asset as well as tax and insurance payments.

Operational leases usually include a renewal option since the economic life of the asset is generally relatively longer than the lease term. This allows the lessee to renew the lease of the asset at the end of the term of the lease. A purchase option may be included at the end of the lease which will allow the lessee to acquire the asset.

Under an operating lease, a lessor transfers to lessee only the right to use the asset. The lessee does not have any level of ownership over the asset. Under an operating lease, periodic payments, as per the lease agreement, are recorded as expenses in the income statement. Operating lease expense is not recorded in the balance sheet.

Consequently, under an operating lease (compared to capital lease), financial ratios present misleading results. For example, leverage ratios are understated because no liability is recorded associated with the lease. For example, the debt-equity ratio is lower and so is the debt ratio. The times interest earned ratio is higher because under an operating lease, depreciation is not recorded.

Liquidity ratios are also affected. Both, the current ratio and quick (Acid-Test) ratio are overstated because the lease is not reflected in current liabilities. Moreover, the ROA profitability ratio is overstated because total assets are not affected under an operating lease.

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