Capitalizing Operating Leases

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Capitalizing Operating Leases

The principal advantages perceived by companies who enter into leases are:

• They are able to use the assets in their business without showing the related debt. Companies improve the utilization of their assets via leasing since they can add capacity, as needed, a lot more easily by leasing rather than committing to own the assets.

• They show no interest expense or depreciation in the income statement, although both of these are part of the “lease expense” account that does run through the income statement.

• They avoid certain risks of ownership such as technological obsolescence, physical deterioration, etc. If one of these situations arises, the may terminate the lease, although there may be a penalty involved.

• If the lessee is in a lower marginal tax bracket than the lessor, leasing is advantageous to both parties. The lessor can take advantage of any accelerated depreciation tax shields available to them and some of this benefit is usually passed on to the lessee in reduced lease payments.

Operating leases are leases that fail all of the following four tests under Financial Accounting Standards (FAS) No.13 and, therefore qualify for off balance sheet treatment:

1. The lease transfers ownership of the asset to the lessee by the end of the lease term.

2. The lease contains an option to purchase the leased property at a bargain price.

3. The lease term is equal to or greater than 75% of the estimated useful life of the leased asset.

4. The PV of the lease and other minimum lease payments equals or exceeds 90 percent of the fair value of the leased asset.

Most analysts will proforma these operating leases back into the company’s financial statements to get a more proper view of their true debt and related expenses – in other words, as if the company bought the asset outright and took on debt to finance it. As an example, the following is the leasing...
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