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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Leasing

A lease is a contract between tenant (a lessee) and owner (a lessor) of the asset which allows the tenant to use owner’s property over specified period of time in exchange for periodic payments which the lessee makes to lessor. The contract must be signed by both lessee and lessor and is usually called a lease agreement.

Leases can be arranged for both tangible and intangible assets. Lease of tangible assets is lease of assets that one can see and touch and includes assets such as automobiles, buildings and equipment. Lease of intangible assets is a lease of assets that one cannot see and touch. An example will be a lease of use of a radio frequency.

Leasing is a substitute for purchase of a fixed asset. It is one of the ways in which an organization can finance its assets. It allows the firm to make use of an asset in exchange for contractual periodic payments which are tax deductible.

 

Financial Position Statement Format (Balance Sheet)

As we mentioned earlier, a balance sheet (financial position statement) is one of the most important financial statements. Other important financial statements include the income statement, cash flow statement and statement of changes in equity. A balance sheet (financial position statement) outlines the financial position of the company at a given point in time. It is often called a “snapshot” of the company’s financial position.

Below we present the general format of the balance sheet (financial position statement). We also explain the items in the balance sheet.

General balance sheet format


(1) ASSETS

(1.1) Current assets comprise:

Cash

+

Marketable securities

+

Accounts receivable

+

Inventories

=

Total current assets

(1.2) Non-current assets (fixed assets) comprise

Land and buildings

+

Machinery and equipment

+

Vehicles

+

Fixtures and Furniture

+

Other (for example financial leases)

=

Total gross fixed assets

Less: Accumulated depreciation

=

Net fixed assets

+

Other assets (investments, goodwill, copyrights and patents)

=

TOTAL ASSETS

(2) LIABILITIES AND (3) EQUITY

Liabilities comprise current and non-current liabilities:

(2.1) Current liabilities:

Accrued expenses

+

Accounts payable

+

Short-term notes (notes payable)

=

Total current liabilities

(2.2) Non-current liabilities

Mortgage

+

Other long-term debt

=

Total Non-current liabilities

(3) Equity comprises:

Common stock

+

Paid-in capital in excess of par on common stock

+

Preferred stock

+

Retained earnings

=

TOTAL EQUITY

=

TOTAL LIABILITIES AND EQUITY

Assets


CURRENT ASSETS

Current assets are listed first in the balance sheet (financial position statement). Current assets are those that can be converted into cash within 12 months. The main reason why small businesses often experience financial trouble is inefficient management of current assets. That is, they run out of cash. This can happen for such reasons as having insufficient cash on hand or underestimating the amount of time it takes to liquidate assets to create cash.

Marketable securities, also often called “near cash”, are liquid securities such as US Treasury bills.

Accounts payable refer to money that has not yet been received from the firm’s debtors. Debtors are the firm’s customers who bought from the firm on credit and still need to pay for a product or service provided.

Inventories refer to the raw materials, products in the process of production and completed products ready for sale. Basically, inventory is the physical products the business intends to sell.

In the balance sheet (financial position statement), the most liquid assets are usually listed before less liquid assets. That is why we also listed current assets in terms of decreasing liquidity: cash, marketable securities, accounts receivable and inventories.

NON-CURRENT ASSETS OR FIXED ASSETS

After current assets are listed, we can list non-current assets in the balance sheet. Non-current assets or fixed assets refer to assets that cannot be converted into cash within a 12 months period. The majority of fixed assets are depreciable. It means that the cost of the asset is allocated over its useful life and deducted as expenses on the income statement. This decreases the amount of tax the firm has to pay.

On the balance sheet we need to show the net fixed assets, which refer to the gross fixed assets (assets before depreciation is taken into account) less accumulated depreciation (depreciation deducted over the useful life of the asset, up to this point). The net fixed assets of the firm is also referred to as the book value.

OTHER ASSETS

Other assets show assets on the balance sheet that do not fit under the first two categories and include such assets as goodwill, copyrights and patents. For some companies this can contribute a sizable portion, if not the majority, of their value.

Liabilities and equity


The second part of the balance sheet presents how the business was financed. It basically shows from which sources assets were financed. The two main sources of financing are debt and equity.

CURRENT LIABILITIES

We start the second part of the balance sheet with current liabilities. Current liabilities include accrued expenses, accounts payable and short-term notes.

Accrued expenses are expenses which the company is obligated to pay within 12 months and includes such items as salaries and wages.

Accounts payable refer to payments that company is still obligated to make within 12 months to the creditors which supplied their product on credit to the company.

Short-term notes refer to the money that must be repaid to the lenders within 12 months.

LONG-TERM LIABILITIES

The next step in compiling the balance sheet requires us to list long-term liabilities. Long-term liabilities refer to debt payment which is due in a period longer than 12 months.

EQUITY

The last step in compiling the balance sheet requires us to illustrate the equity position of the firm. Equity indicates the claims of firm’s owners on the firm.

Items “common stock” and “paid-in capital in excess of par on common stock” indicate the amount paid by common stock shareholders for their shares of common stock.

Preferred stock shows the amount of money received from issuing preferred stock.

Retained earning show the earnings of the firm which were not distributed in the form of dividends to the shareholders.

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Long term sources of finance

Here we will focus only on the long term sources of finance because only long-term sources provide permanent financing. Long-term sources of finance (also called long-term sources of capital) refer to long-term debt and equity on the balance sheet. They include long-term debt, preferred stock and common stock equity, which in turn include issues of new common stock and retained earnings.

Permanent financing generally refers to financing long-term fixed assets, such as machinery or factory. If the pay-off from the asset is over the long-term period (longer than 1 year), the long-term sources of finance should be used to ensure it is less risky to finance such assets. For example, if long-term debt (one of the long-term sources of finance) rather than short-term debt is used, business can be more certain money will be available to cover obligations as they come due.

While focusing on the long-term sources of finance, we will need to focus on the specific cost of finance. We will need to obtain the specific cost of each of the long-term sources of finance, which refers to the after-tax cost of using each of the sources today.

Read related article: Cost of Long Term Debt 

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

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