General incentives for leasing:
Finance versus Operating Leases
Operating leases allow the lessee to use the property for only a portion of its economic life.
In an operating lease the lessee is not seen as becoming the owner of the asset. In a capital lease the lessee is seen as becoming the owner.
Capital leases (CL) involve effective transfer of all risk and benefits of property to the lessee. For accounting purposes the transaction is treated as though the lessor has granted the lessee a loan to purchase the asset. The lessee recognizes the asset and a loan on its balance sheet and treats the lease payments as part of interest expense, and part of repayment of the principal on the loan. The lessee then also recognizes depreciation on the asset.
Generally lessees prefer leases to be classified as operating leases. They do not have to recognize the asset and loan on their balance sheet although they still receive all of the benefit of using the asset. Therefore operating leases result in higher profitability ratios and reduce reported leverage for lessees.
Generally lessors prefer leases to be classified as capital leases. This allows them to potentially recognize a profit on the sale of the asset, though the substance of the transaction is similar to installment sales or financing. This also allows them to be able to derecognize the asset from their balance sheet.
A. High effective tax rates.
If a firm has high level of debts already, adding a capital lease will increase its debt, which could affect the debt ratios unfavorably.
A. capital lease
An operating lease is a conventional rental agreement that does not transfer ownership rights to the lessee at the end of the rental term.
I. It is easier for a lease to be classified as an operating lease under IFRS standards than under GAAP.
I is true. IFRS standards lack the quantitative criteria of SFAS 13.
A. The firm has debt covenants that restrict the amount of debt
When a firm is in a high tax bracket, there are certain tax advantages to owning assets, and a capital lease would increase asset ownership.
A. Lessee is in a high tax bracket.
Capitalizing a lease increases total assets and the capital base. This discourages capital leases as profits have to be higher to meet or exceed return on capital benchmarks.
A. The lessor records depreciation expense and lease revenue.
For operating leases the lessee records rent expense and the lessor would record the related revenue and would amortize the asset.
A. Results when the lease term is less than 50% of estimated economic life.
It is reported on the balance sheet.