Capital Leases Vs. Operating Leases
The two types of leases have VERY different effects
on the balance sheet, income statement and
statement of cash flows and thus can be used to
manipulate the firm’s reported financial position.
– What are the effects?
– You should be able to identify whether a firm uses one
or the other type of lease.
– You should be able to “convert” one type to the other
to compare firms that use different types of financing
and assess a “true” financial picture of the firm.
Types of Leases
• Operating Leases: No transfer of the risks
and benefits of ownership
• Capital Leases: Transfer of the risks and
benefits of ownership
Capital Lease Conditions
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A lease is a capital lease if it meets at least one
of the following conditions:
Lease period is  75% of the asset’s useful life
PV of the lease payments is  90% of the
market value of the asset
Bargain purchase option
Transfer of ownership to lessee
Operating Leases
• No asset or liability
– if you didn’t get the risks and benefits of
ownership you shouldn’t show a liability or
asset.
• Rent expense reduces net income and is an
operating cash outflow
Capital Leases
• Record an asset and a liability in the amount of
the present value of the future lease payments
– You received the risks and benefits of the asset, so
treat the transaction as if you financed the purchase
with debt.
• Amortize the asset (NOT a cash outflow!)
• Show interest expense (operating cash outflow)
and principal payments (financing cash
outflow) on the liability
Converting Operating Leases to Capital Leases
Why do this?
• Firms that use operating leases ultimately have
the same usable resources and financial
obligations as those using capital leases.
• The obligations should be shown!