Question

Explain why many companies would prefer to account for a lease as an operating lease as opposed to a capital lease (answer from the lessee’s perspective). Be sure to focus on the impact of the type of lease on BOTH the balance sheet and income statement

Answer 1

Answer:

In Operating lease,

lessor only transfers the right to use the asset to lesse and the asset is returned to the lessor after the lease term.

Since lesse does not bear the risk of ownership, therefore lease expense is treated as the operating expense in the income statement by the firm and it does not affect the balance sheet.

In Capital Lease,

Lesse assume the ownership of the assets and the underlying asset is recorded in the balance sheet as asset and minimum of present value lease payments and fair value of the asset is recorded as lease liability.

The interest expense is imputed on the lease liability. For company's which uses a significant amount of operating lease, converting it to capital lease will increase the lease liability i.e. debt of the company which company's don't want to increase.

Thus Companies prefer operating lease compared to capital lease because of following reasons:

1) Companies are protected from the risk of obsolescence of the asset

2) It helps them to keep the lease off the balance sheet which helps them to show lesser debt on the balance sheet

3) Companies can update or replace equipment more frequently

4)) Operating assets increases the return on assets as no assets are recorded in the Balance sheet.