Capital versus operating Leases Capital versus operating

Leases Agreement giving the right to use PPE for a set time period Lessor – the owner of the property who gives up the right to use it to the lessee Lessee – acquires the right to use the property from the lessor Like a purchase /sale of PPE with 100% financing, Tax implications Convenience May allow reduction in risk Off balance sheet financing Cancellation impact

How are leases classified? Operating Lease Capital Lease Simpler Off balance sheet financing (no asset and liability) Short-term lease more common Rent expense and rent revenue recognized More complicated Asset and liability listed –valued at present value of minimum lease payments not to exceed fair value Substance over form (faithful representation) Transfers ownership of property Long-term lease more common

Capital leases “pretend purchase” Lessee – if at least one capitalization criteria of the following is true: 1. Transfers ownership of property to lessee by end of lease term 2. The lease contains a bargain purchase option 3. The lease term is equal to at least 75% of estimated economic life of property 4. The present value of minimum lease payments is equal to 90% or more of fair value of leased property to lessor Lessor – if the above is true and the following 2 additional items are true 1. The collectability of the minimum lease payments is reasonably assured 2. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by lessor “pretend purchase” Transfers substantially all the risks and benefits of ownership

Capital lease Record “leased” asset –value is present value of minimum lease payments Interest rate is the lessor’s implicit interest rate if known and it is lower than lessee’s rate -- use lessee’s rate if lessor not known or higher than lessee rate Record liability on lease Depreciate leased asset Accrue and pay interest as part of lease payment Recorded very similar to a purchase with a high level of financing for the lessee

Capital lease Sales-type lease: Direct financing lease: For the lessor Sale of asset creation of a receivable Cost of goods sold and sales revenue Inventory comes off the books Unearned interest revenue becomes Interest revenue Direct financing lease: Creation of a receivable A PPE asset comes off the books Unearned interest revenue becomes Interest revenue For the lessor