Question

Why is lease financing sometimes referred to as off-balance sheet financing?

It appears likely that the FASB and IASB will require all leases to be capitalized, even those that are now classified as operating leases. In fact, they have agreed that the leases should be shown on the balance sheets, but they are still debating how to recognize the lease-associated expenses on the income statements. This could have a huge impact on many companies’ financial statements. For example, Credit Suisse estimated that the S&P 500 firms use about $369 billion in assets that are in the form of operating leases. As such, these are not shown as either assets or liabilities and instead are off the balance sheets.

Explain how the cash flows are structured in order to estimate the net advantage to leasing.

What discount rate should be used to evaluate a lease? Why?

Define the term net advantage to leasing (NAL).

Answer 1

1. Off balance sheet financing as the name suggests is the mode of financing where the organisation doesn't acknowledge the liability of financing on its balance sheet or books. SO for eg in case of operating leases only rental of the lease are entered in the income statement where in essence we have taken a loan to get that equipment onboard with us. But still no long term liability features in the books.

2. The structure to estimate is as follows :

Find the Net present value of the borrow and buy alternative.

Find the Net present value of the leasing alternative

IF latter is more than the former deduct them

the result is Net advantage of leasing

3. As per IFRS 16 Leases we should not use the implicit rate of return of the lease arrangement as Discount rate. The best way is to find out the borrowing rate available in the market to acquire the equivalent asset in borrow and buy mode. That borrowing rate will be correct representative of the discount rate.

4. NAL is the excessive of present value of lease alternative over borrowing alternative, calculation of which has been explained in part 2.

Please let me know in case of any doubt.