CFA Practice Question
Operating leases ______
II. cause lower tax payments compared to capital leases.
III. lead to lower income variability.
I. allow off-balance-sheet financing of capacity.
II. cause lower tax payments compared to capital leases.
III. lead to lower income variability.
A. II and III
B. I and III
C. I, II and III
Explanation: Since operating leases do not appear on the balance sheet, they allow firms to harness extra operating capacity without the financing showing up directly. Note that the total tax deductions under a capital lease and an operating lease are the same over the life of the leases. A difference is that a capital lease allows higher deductions in the initial years and lower deductions later on, leading to lower income tax payments and lower reported income in the initial years. This effect reverses in the later years. Thus, the income variability is lower under an operating lease.
User Contributed Comments 10
| User | Comment |
|---|---|
| ticomico | Not to take Capital Lease for Capitalising expenses. Capitalising expenses creates lower income variability than expensing them. On the other hand, a Capital Lease creates more income variability. |
| danlan | Ticomico, good comments. Difference between capitalising expense and capital lease is that the latter one (lease) is related to an interest payment, which is related to a liability when capitalized. |
| mtcfa | Lease also has depreciation factored in. |
| steved333 | yeah, like a mortgage payment, more of the initial payments are comprised of the interest expense, and more of the later payments are comprised of the principal. |
| mixer | what is income variability |
| reganbaha | when income is variable |
| ashish100 | Wouldn't capital lease allow assets to be depreciated causing lower net income and lower taxes compared to operating lease? Please help. |
| Horv | Was struggling on this because I wasn't assuming that lease payments in this scenario are Identical. Capital Lease payments will always be less (in a vacuum) in regards to the income statement as the principal portion will only hit the Balance Sheet. |
| Horv | Ashish, you are correct. Thats why II is not the correct answer. |
| jeeychung | Why Capital lease high deductions in initial years? |