Economics Finance

When an organization wants to purchase assets they sometimes choose to lease assets rather than buy them out right. This type of financing offers many advantages to an organization, but they should keep in mind how the proposed lease will affect their overall financial position. The two kinds of leases that an organization can choose from is an operating lease or a capital lease. Both of these leases will in effect provide financing in order to acquire an asset, but the effects of each are accounted for differently and are reflected differently in organization’s financial statements.

An operating lease is the straightest forward of the two. The lessee (the organization) makes an agreement with the lessor (seller of the asset) for the use of an asset. Basically the organization is renting the asset with an installment payment (which usually includes interest) with intentions to return the asset when the lease ends. An example of an asset that would be commonly financed with an operating lease is new technology. Because technology is going to change, it is often better to lease the asset rather than commit large sums of an origination’s capital to an asset that is going to need to be upgraded every couple of years. The accounting for operating leases is quite simple. Because an organization does not own the asset, it is not recorded on the firm’s balance sheet. The only effect that an operating lease has on organization’s financial statements is the lease payments will appear as an operating expense on the entity’s income statement. Since an operating lease is not recorded on the balance sheet, it is sometimes referred to as off balance sheet financing. The main advantage of an operating lease is that the organization can use the asset without the usual attributes of ownership (i.e. the liability that would come with financing an asset and the depreciation expense that would come with an owned asset). Another advantage of an operating lease is that since it is not treated as a liability the organization will maintain their current access to capital. That is because the lease payments are not treated as debt and this helps the organization to maintain their current debt capacity. Thus the organization is able to use the asset to produce revenue, and is able to maintain its current access to the capital markets through debt.

When leasing an asset, most originations would like to keep any leases off their balance sheet, and not show an asset or a liability for the financing of assets (with would occur in ownership of an asset that is traditionally financed). With this in mind the Financial Accounting Standards Board (FASB) in 1976 issued Statement of Financial Accounting Standards No. 13 which basically stated that a lease agreement would be considered a capital lease if it meets any one of the following criteria:

1) If the lease life exceeds 75% of the life of an asset
2) If the lessee is to purchase the asset for a bargain price at the end of the lease (usually $1)
3) If there is a transfer of the ownership of the asset at the end of the lease
4) If the present value of the lease payments exceeds 90% of the fair market value of the asset

If the lease is considered a capital lease then the asset being leased will show up on the entity’s balance sheet. The leased asset will be represented as if the organization owned the asset, and all of the lease payments over the life of the lease would be accounted for as if they were a liability of the organization (by an amount equal to the present value of the minimum lease payments). Basically the asset financed as a capital lease would show up on the organizations balance sheet as if they had borrowed the money to purchase the asset; thus negating any advantages of the operating lease which keeps the asset and the liability off the organization’s balance sheet. The asset would also be depreciated like any other asset that the organization owned out right. The lease payment for a capital lease would flow to the firm’s income statement as an expense which would have two components. One of the components of the lease payment would be the interest portion which would be shown as an expense on the organizations income statement. The Second component is the principal payment which would also show up as an expense on a firm’s income statement.

As you can see both of these lease types are accounted for in very different ways which each in turn will affect an organization’s financial statements in different ways. These effects need to be considered when an organization makes its decision to use a lease as its vehicle to finance assets. Investors and Creditors of an organization must also take into account what kind of leases a firm is engaged in. If you were to look at an organization’s balance sheet in deciding if you should invest money or loan money to an entity, the firm could have several operating leases that would not show up on this statement. If the firm is over loaded with operating leases this could change the mind of an individual/institution that might want to invest money in the organization or loan money to the organization. This also comes into play when firms are being rated by the different rating agencies. Even though the firm’s balance sheet shows that they have very little debt it becomes more important to know how much the firm has financed assets using operating leases; which in essence could take a company that looks very credit worthy based on their balance sheet but in reality they have more debt than they can handle. Given this problem it could be a very short time until the benefits of an operating lease are taken away, and all leases are treated as capital leases.