Capitalizing a Lease

CFA Level I FRA
#1

Question below;

During a period when net income is unexpectedly weak, managers who attempt to smooth earnings are most likely to:

A. capitalize an expense

B. capitalize a new lease

C. classify a nonrecurring gain as recurring income.

Answer: A

Explanation: Management may attempt to increase reported earnings in the current period by capitalizing an expense. Capitalizing a lease would decrease earnings in the current period compared to recording an operating lease. Classifying a nonrecurring gain as recurring income would not increase net income because it already includes nonrecurring gains.

Basically my question stems from this explanation more than the actual question. I understand why capitalizing an expense is beneficial to smoothing earnings but I’m having a hard time understanding how capitalizing a lease decreases earnings more than recording an operating lease. Picturing the whole equation in my head I assumed that the total of depreciation and interest on the capital lease (with interest making up a larger portion of the payment in the earlier years than in the later years of the capital lease) matches the lease payment on the operating lease.

At the end of the day its not hard to remember that a capitalized capital lease has lower NI in the early part of the lease and higher NI in the later part of the lease but I am just trying to wrap my head around the whole picture.

#2

Under an operating lease the lease payment is reported as an expense (Rent Expense).

Under a finance (capital) lease the interest portion of the lease payment is reported as an expense (Interest Expense), as is depreciation (Depreciation Expense). Under straight-line depreciation, the sum of depreciation and interest is generally higher in the early years of the lease than the lease payment; thus, by capitalizing the lease you will decrease net income in the early years.

#3

This is under the assumption of it being the lessor, correct?

#4

Nope: lessee.

Under a capital lease the lessee is essentially buying the item on credit; they record an asset and a liability on their balance sheet, and depreciate the asset.