Suppose a non-cancelable lease begins on Dec. 31, 20X0 with annual lease payments of $10,000 made at the end of each year for four years. Ten percent is assumed to be the appropriate discount rate.
Operating Lease for a Lessee
Operating Lease for a Lessor
Capital Lease for a Lessee
An OL charges constant rental payments to expense as accrued, whereas a CL recognizes and apportions depreciation and interest expense over the term of the lease.
Capitalization results in a higher EBIT, as the straight-line depreciation expense of $7,925 is lower than the OL rental expense of $10,000.
CL interest expense falls over time and depreciation expense is constant (straight-line depreciation) or declining (accelerated depreciation method). Total expense for CL declines over the lease term. Initially, it's higher than OL expense but over time it becomes lower. Tax expense and net income for an OL are constant over time. Tax expense and net income for a CL increase; for a CL, one also reports an accumulating deferred tax expense.
Compared to a CL, firms using an OL generally report higher profits, interest coverage, and ROA. Lease expense (for CL=$11,095) exceeds lease payments (for OL=$10,000), so there will be a deferred tax credit. The deferred tax amount increases until the lease expense is less than the lease payments, and then the account declines and is eliminated by the end of the lease.
No deferred tax is reported for OL, since the amount deductible for taxes and reported lease expense are always the same. Total (interest and depreciation) expense for a CL must equal total rental expense for an OL, over the life of the lease. Net income is not affected by CL but CL reports lower income earlier in the lease term and higher income later.
Under an OL, all cash flows are operating and there is an operating cash outflow of $10,000 per year. Annual payments of $10,000 create a tax benefit of $3,500 per year, which is deductible regardless of the lease method used. CL produces operating cash flows (CFO) and financial cash flows (FCF). The $10,000 paid under the CL is allocated between interest and amortization of the lease obligation (reported as cash from financing).
For a CL, as interest expense declines over the term of lease and an increasing portion is allocated to the lease obligation, the difference in CFO increases over the lease. CL therefore decreases operating cash outflow while increasing financing cash outflow.
Note that under IFRS the interest expense portion of the lease payment can be treated as either operating or financing cash outflow, but under U.S. GAAP it is treated as operating cash outflow.
Summary (For a Lessee):
All other factors remaining equal, firms reporting operating leases will report better performance because:
|papajeff: well, that's totally clear....and now forgotten.|
|Sheeb: Amen brother.|
|Ewan2015: Don't worry it changes in a year anyway and the differences will become negligible between the two.|
|sdm1981: For operating leases. If the lessor holds the asset do they also depreciate it on their BS? I know they record the revenue earned from the lease|