“Relative to operating leases, capital leases provide a lessor with earlier recognition of profit, larger assets, and lower CFO” Why larger assets? If a lease is structured as capital lease, then lessee will “claim” ownership and recognizes asset and liability on its balance sheet (which increases lessee’s assets). Since lessee already recognizes it on its balance sheet then the lessor cannot (so assets will be smaller). If it’s a operating lease, then the lessor can recognize it on its balance sheet. What’s wrong with my reasoning? Your help is greatly appreciated. Thanks.
Since > lessee already recognizes it on its balance sheet > then the lessor cannot (so assets will be > smaller). This is incorrect. The lessor can also capitalize the assets as long as the 4 rules for lesse capitalization + 2 rules for lessor capitalization are satisfied. The lease can becapitalized by both lessee and lessor at the same time. The only combination that is not allowed is :lessee classifying it as operating lease and the lessor as capital lease at the same time since it violates the 4+2 combined requirement
OMG. Where did you get this 4+2 rule? How come I never read about it? It’s definitely not in Schweser notes! What does the 4+2 rule state? So are you saying if lessee recognizes it as operating lease, then the lessor must also recognizes it as operating lease? (since you said lessor cannot classify it as capital lease) Thank you so much.
It is on Page 1 or 2 of the Lease chapter. Rules 1 thro’ 4 are for a Lessee Rules 5 thru 7 are for Lessor. CP
sorry 4+2 is my personal mnemonic: the rules to determine if a lease can be capitalized by a lessor being first the lesse has to capitalize the lease based on: 1 - bargain option present? 2 -life of lease >75% of asset’s economic life 3. PV of lease >90% of fair value (lower of lesse’s borrowing cost or lease’s implicit rate) 4)title transfer at end of lease + the below 2 additional conditions for the lessor 1. predictable lease payment collectibility 2.no uncertainities about amt of unreimbursable costs yet to be incurred by lessor.
don’t worry…you know what those 2 are… 1) Collectibility of payment is assured 2) no uncertainities about significant un-reimbursable costs yet to be incurred. If the lease satisfies any of the 4 conditions that are required for the lessee (>75% of economic life, bargain purchase option, PV>90% of fair val & tittle is transferred), then the lessor must classify the lease on his/her B/S as capital lease if both of the above 2 are met.ie. it goes on balancesheet
page 222 book 3 schweser are your 4 lessee requirements.
thanks all ok, this might be a dumb question: if it passes the first 4 criteria but fails the last 2, then lessor must classify it as operating lease? Really appreciate it.
That is correct, if it does not satisfy both the condition it will be operating lease, in that case no balancesheet impact, and revenue is recognized as earned…ie when payment is received
Thanks all for your help. I really appreciate it.
sleepybird Wrote: ------------------------------------------------------- > thanks all > ok, this might be a dumb question: if it passes > the first 4 criteria but fails the last 2, then > lessor must classify it as operating lease? > Really appreciate it. just a quick point that a lease doesn’t have to pass all 4 criteria. As long as it passes 1 out of 4, it’s classified as a capital lease.
sleepybird Wrote: ------------------------------------------------------- > “Relative to operating leases, capital leases > provide a lessor with earlier recognition of > profit, larger assets, and lower CFO” > CFO is higher in year 0 for lessor and lower in later years for sale type lease.