Question

5 The preferred response will include an explanation in your own words, and a good example.

Why is leasing sometimes referred to as “off-balance sheet financing? Discuss the four conditions that would require a lease to be classified as a capital lease.

Answer 1

Leasing is sometimes referred to as “off-balance sheet financing There is a following reason behind that.

Let's first understand what is " Off balance sheet financing". Basically it is aliablity that compnay does not need to mention on its balance sheet on Liablity side. Thus, it makes look financials strong and sound.

Now suppose compnay wants to use a building for a plant or other business purpose. That building can be acquired in two ways. First one is by paying the price of building immediately and writting this building as an asset and same amount on Liablity side. Second way is company just keep the building on operating lease. It means they just pay the rent for it. And it will cost them less amount of money per year.

Thus, they didn't show any liablity for the building but compnay is using that asset in the same way as the first case was. That's why It is called off balance sheet financing.

4 conditions that require a lease to be classified as capital lease.

1. Transfer of ownership between the two parties that is between lessor and lesse.

2. Period of the lease should be at least seventy five percent of useful life of that particular asset.

3. PV of all the payments that will be made for that particular asset should be at least 90% of the value of that asset.

4. There should be an option of bargain price purchase option. It means that price should be less than the market value of the asset that is to be leased.