Question

Why would a company try to classify leases as Operating Leases instead of capital leases in order to finance their operations?

Company A reports Revenues of $5,000,000, COGS of $350,000 and net income of $75,000. Gross Inventory is $250,000 and the Accumulated Depreciation $75,000. Total assets are $3,000,000 and Equity is $1,000,000. Company B reports Revenues of $3,000,000, COGS of $175,000. Gross Inventory is $200,000 and the Accumulated Depreciation $75,000. Total assets are $2,000,000 and Equity is $500,000. Discuss and support your discussion with calculations.

Answer 1

A company may opt or try to classify leases as operating lease due to below advantages,

1. Equipment will not be used long-term. It doesn’t make sense to make a large cash outlay for equipment that will only be used for a short period of time.
2. Your equipment will become outdated quickly. If technological advances in your industry tend to make your equipment obsolete every few years, a short term lease can help you stay up to date.
3. Cash flow is tight. With a lease, you avoid a hefty up-front charge, and you can make payments as you generate cash flow with your new equipment.
4. You want to protect your balance sheet. An equipment purchase is recorded in your balance sheet, which increase your debt and reduces your available cash. In contrast, most leases are not recorded as debt, and are treated as an operating expense.
5. You want the tax benefits of leasing. One of the most popular advantages of operating leases is the potential tax benefits. A lease may allow you to deduct your payments as operating expenses during the period in which you pay them. If you purchase equipment, you may be able to deduct the interest, as well as the cost of the depreciation.