I am using the Schweser study bank and got the following questions: "For a lessor, assuming all other factors are constant, a sales-type lease will result in higher: A) interest revenue as compared to a direct financing lease. B) cash flow from operations (CFO) as compared to a direct financing lease. C) cash flow from investing (CFI) as compared to a direct financing lease. Your answer: B was incorrect. The correct answer was C) cash flow from investing (CFI) as compared to a direct financing lease. The sales-type lease has higher CFI (collection of lease receivable is considered a CFI) and lower CFO (interest revenue is considered a CFO) as compared to a direct financing lease. This results from the difference in the implicit rate among the two lease types. " I do not understand this answer. I picked B, because I figured the gross profit from Sales-Type lease goes to CFO. It seems to me both types of leases have exact same lease receivables and hence exact same CFI. If anyone could help me understand this, I would be very grateful.
Maybe try to think about it as an investment transaction CFI (fixed asset) purchase and sale, recognizing NPV of the income from the asset in one period, because the sales type lease causes the asset to be recognized more as a financial firm would conduct businesses. Buy an asset, recognize instant appreciation, then sell it, vs buy an asset, use it to generate income from continuing operations, then sell it. I think I just confused myself, but maybe someone else has a better explanation.
C is correct. CFI for a direct financing lease is zero. From the lessor’s point of view, only a Capital Sale Type Lease would effect CFI. Capital Direct Financing and Operating Lease do not register anything transactions for CFI. Hope this helps!
I believe that is incorrect. Schweser says for both sales-type lease and direct financing lease, you create a lease receivables for the PV of the lease payments. Paying down of the lease receivable is CFI. I think answer from BizBanker explains it. The gross profit from sales-type lease is a CFI not CFO. This makes sense because the lease receivable is CFI. So, I think you treat it as a gain instead of a gross profit. That’s only thing I can think. I still don’t get the Schweser answer because it talks about implict rates.
sueb512 is CORRECT. A direct financing lease is the equivalent of a bank lending a company money to purchase an asset. The principle returned and interest earned is consider operating cash flow, not an investment since they are in the business of lending money. Direct Financing does not effect CFI, only CFO. With a sale type lease, the interest revenue is classified as CFO and the reduction in net lease receivables is classified as CFI. This applies to the Lessor, for the Lessee, it is different! And remember, these are accounting standards and there is no rhyme or reason as to why these transactions are classified the way they are.
Wait a second. I don’t understand why CFI is not affected under a direct financing lease. Isn’t the principal portion of the lease payment that you receive an addition to CFI while the interest portion is CFO? I think CFI is higher because you are assuming a lower rate (to use for PV) for the sales type lease vs. direct. This would yield a lower interest component and a higher principal component when dividing up the lease payment when compared to direct financing lease which is assumed to have used a higher rate. But then again, the question is very ambiguous because it says that “all factors are constant…”
CFI does get effected by the principle for Direct Financing. core-models.com has an excellent model for Capital vs. Operating Lease. You can see in the model why CFI is higher for a Sale Type Lease compared to a Direct Financing Lease. Basically the principle repayment is the same for both methods when the residual is $0, however, with a direct financing lease you record a negative value at Year 0 for the FMV. For the sales type financing, you record negative profit for CFI and positive profit for CFO at year 0. Hope this helps.