# EOC FSA pg 112, capitalizing interest, operating vs. capital lease

#8, the way I’m interpreting this is since we are capitalizing the interest, it’s now part of the “capital” asset, so fixed assets go up, OK i get that. But if you look at the answer to #8, it is saying to use interest PAYMENTS rather than interest EXPENSE. I don’t know the difference between these. Then it goes on to say how you should use the ENTIRE amount of interest expenditure, which I think it’s trying to say use interest PAYMENT which represents the entire amount (both capitalized and expense portions). #9, I get it, but if you look at the answer, I have seen this before but never fully understood why exactly the lease expense of an operating lease is LESS than the sum of the interest & depreciation expense (which exists in a capital lease?), and then that reverses later on? Thanks, Andrew

#9, I get it, but if you look at the answer, I have seen this before but never fully understood why exactly the lease expense of an operating lease is LESS than the sum of the interest & depreciation expense (which exists in a capital lease?), and then that reverses later on? without the need to show an example, cause you know me and FSA are enemies… we know they are both gona give you the SAME total expense over their life time, agree? well since interest expense goes down as your principle is going down, the capital lease must occur less interest at the end and more at the beggining… thus the capital expense will be more than the operating at first, then it would reverse… hope it helps, i dont feel like reading the first question lol

seems like i’ve been throwing this example around a lot, but here it is again: o Ex. Lease PMT \$200, r = 5%, lease term = 10 years, PV = 1544.35 o In the first year of the lease, you would have: „X Lease payment of \$200 „X Interest expense of \$77.22 (operating CF) „X Principal Payment of \$122.78 (Financing CF) „X End of year lease PV of 1421.57 (1544.35 ¡V 122.78) „X Depreciation expense of whatever; (management would choose depreciation method) we’ll assume straight line depreciation with \$100 salvage value over 10 years. also, we’ll assume the book value of the asset \$1550 depreciation = (1500-100)/10 = 140 then your interest expense = 77.22 so the two combined come to 227.22, ie greater than your \$200 lease payment. the difference is more pronounced if you go with a double declining depreciation, which I don’t feel like doing right now… anyway, depreciation would keep being 140, but interest expense will be lower than 77.22 every year, and at some point \$140 + int expense < \$200. this should spell out pretty clearly why net income would be lower initially under a capital lease than under an operating lease, but I haven’t got a text in front of me and don’t know what #9 asks, but I kicked that reading’s @ss so I feel like this is probably helpful. if not, sorry bout that.

Thank you magic, awesome, I think schweser probably has an example like this too that I should go over. Interest expense goes down every year is the key, because it is based off a smaller PV of the lease b/c we are paying that sucker down. Did you mean to say "we’ll assume book value of the asset is 1500, rather than 1550? Thanks again.

lol oo ya, right. obviously i did’t pay too much attention; tbh it doesn’t matter whether you call it 1500 or 1550, end result is the same, and i think there’s a little discretion around what the company calls the book value of it, but it should at least approximate the pv of the lease payments.

^ i mean end result, in terms of the concept being shown, obviously there would be a small dif in depreciation amount. anywho, good luck on this thing, it is a 13itch

for number 8, i just did this Q today. and I got it wrong. Book says interest coverage should be unchanged. Interest coverage ratio= EBIT/Int expense Because EBIT is found on the income statement the line before interest, EBIT does not change. But I have hard time trying to figure out why interest expense would also stay the same. can someone explain?

Ok I reread the book again and I am going to try to answer my own question. Regardless of how the company treats interest expense, Interest coverage should always be calculated as if the interest expense has been expensed…therefore, EBIT does not need to be adjusted, because it is already calculated including all interest expenses… make sense?

i dunno, who cares. what do you mean ebit already includes all interest expenses, you supposed to not deduct interest if you wanna calculate ebit… not sure what you mean

yes, you just include the (denominator) as WHOLE INTEREST PAYMENT, AKA the whole check I write for interest, doesn’t matter what part is capitalized or expensed

Just use both capitalised interest and interest expense as per the IS in the denominator, do not think EBIT needs to be touched