Question

Discuss the impact of lease capitalization on various financial variables/ratios and the possible motivations of firms to report leases as operating leases.

Answer 1

Capitalizing a lease can have an impact on both assets and liabilities of a balance sheet. It is suitable if the leased asset can be bought by the lessee at the end of the lease or lessee gains automatic ownership. The two conditions to measure it are:

a) Lease period is more than 75% of assets useful life.

b) Present value of lease paymnets is at least 90% of the Fair Market Value when the lease was created.

Lease capitalization has following impacts so far as financial variables and ratios are concerned:

1) Debts to assets ratio- It is a leverage ratio which is expected to increase. Because both debts and assets increase due to capitalization.

2) Debt Equity ratio - This ratio will also increase because capitalizing a lease will increase debt while equity remains unchanged.

3) Return on Assets ratio - This ratio will decrease because increase in debt means more payments which reduces profit and assets increases due to capitalizing the lease.

4) Return on Equity ratio - This ratio will decrease because increase in debt means more payments which reduces profit while equity remains unchanged.

Operating lease is suitable for businesses which are already heavilt burdened with debt. Assets obtained on an operating lease can be shown outside balance sheet as an off balance sheet item. Low value assets whose life is less than 12 months that is short term leases can be treated like an opertaing lease that can be shown outside the balance sheet.