Throughout FRA they make note that the rental expense made with regards to an operating lease is EQUAL to the periodic lease payment.
Question: Does this mean that had the lease been a finance lease and not an operating lease (all else equal), that the rent expense under the optg lease would equal the lease payment aount under a finance lease (ie principal and interest) ?
I believe the total cash outflow (payment) would be the same regardless of the classification.
For an operating lease, it is just a simple rental expense in the income statement and an operating cash outflow.
If that same lease were capitalised (finance lease) only the interest on the lease liability is an expense. However, the lessee still makes the same payment, so the remaining amount would be the repayment of the liability. The repayment of the lease is a financing cash outflow and the interest payment would be operating.
But the total outflow is the same, rental expense on an operating lease should be the total lease payment if that same lease was capitalised instead.
My knowledge of FRA is getting rusty … so I’d just like to know if I got this right:
Opperating leases include a residual at the end of the lease. The PV of the pmts must be less than 90% of the fair value of the equipment. As a result the payments do not amortize the full value of the principle. A finance lease is just like a loan and amortizes the full principle over the term of the lease.
Try this. use your TVM function in your calculator. Type in 1000 for PV, 10 for N, 8% for I and 0 for FV. Then solve for PMT
Check out pg 91 of the CFAI FRA book, example 11. They show the different effects on the income statements of a lease that theoretically be capital or operating. The total amound of expense of the life of the lease is the same.
Initially the capitalized lease will show a greater amount of expense, because the Interest expense from the lease amortization will be greater, but you use straight line for the asset. But as the Interest expense declines from amortization the amount expensed will be less than an operating lease.
So an operating lease will have a constant expense for the life of the lease, but a capitalized lease will show greater expense early in its life, but less towards the end. But the cashflow over the life should be the same over the life (not counting investment returns from the initial tax savings under a capitalized lease).
“Initially the capitalized lease will show a greater amount of expense, because the Interest expense from the lease amortization will be greater, but you use straight line for the asset. But as the Interest expense declines from amortization the amount expensed will be less than an operating lease.”
This makes sense becasue the depreciation for a capital lease hits the income statment. It does not for an operating lease. The opperating lease is a fixed rental charge. The capital lease is interst expense and depreciatoin.
“But the cashflow over the life should be the same over the life (not counting investment returns from the initial tax savings under a capitalized lease).”
Again, I will read the example but this makes sense only if they set the example up to work out that way. The cash flows for operating lease will have lower CFO due to the rental expense being greater than the interest expense on a finance lease. If, I recall the principle payments on the finance lease hit CFF so CFF would be lower under a finance lease.
In any case, I would think the total CF would be less for a Operating lease since the payment by its nature is lower than on a financing lease. So the rental expense(opp lease) would be less than the principle + int (finance lease)
I think we’re just conceptually looking at scenarios where the exact same lease could be accounted for either under a capital or operating lease, so the check we write to the leasing company is gonna be the same no matter how we account for it. So there could be a difference in tax treatment, but if we recognize more expense sooner (capital lease), we will have to recognize less later.
I see what your saying. You think they are just assuming the lease is a capital lease with x cash flows. Then they say what if a lease with the same cash flows was deemed an operating lease. In that case, CF would be the same and expenses would be higher early for the capital lease. CF would also be allocated differanlty between the two leases.
Ya, for me my topic would be financial statment adjustments in hyperinflation and calculating translation gains/losses under current rate and temporal. I am hoping that it is just becuase I have not done a lot of sample problems on those topics that I feel weak there.
Though I’ve no clue of it but if the salvage value is 0 then identical total expense under both type of lease arrangements seem logical or else if there is salvage value then it would be adjusted to lower operating lease expense. Or may be the organization stepping into off balance sheet arrangements trade off better ratios with salvage value of the asset by not owning it! As far as the curriculum is concerned total expense is identical!
Yes as 1logic and i were disussing they just took 1 lease and asked how it would be diff were it capital or operating. they are assuming a lease with a residual in either case and i was origionaly thinking they were discussing 1 with a residual and 1 as a full payout. That’s what I get for speaking without seeng the example!