Question

A large number of firms are involved in leases. These leases may include renting of office or warehouse space (typically in the form of operating leases) or the leasing of building and/or equipment, which may consist of capital leases. Our topic on this discussion board is capital leases. Please answer the following questions after reading the assigned chapters.

• What are the four capitalization criteria and which one is not controversial and difficult to apply in practice?
• What are two differences in the financial statement if a lease is recorded as a capital lease instead of an operating lease?
• Select an industry and assume you are an owner of a business in that industry. Share the industry you selected and discuss which would you prefer and why: operating lease or capital lease. Please support your choice.

Answer 1

1. What are the four capitalization criteria and which one is not controversial and difficult to apply in practice

5. Accounting by the Lessee
   • In order to record a lease as a capital lease, the lease must be noncancelable.  

• Capitalization Criteria
• Three of four capitalization criteria that apply to lessees are controversial and can be difficult to apply in practice.
  • Economic Life Test (75% test)
    • If the Lease period equals or exceeds 75% of asset’s economic life, the lessor transfers most of the risks and rewards of ownership to the lessee.
    • A Bargain-renewal option allows the lessee to renew the lease for a rental that is lower than the expected fair rental at the date the option becomes exercisable.
    • At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured.
  • Bargain-Purchase Option Test
    • A bargain-purchase option allows the lessee to purchase the leased property for a price that is significantly lower than the property’s expected fair value at the date the option becomes exercisable.
  • Transfer of Ownership Test
    • If the lease transfers ownership of the asset to the lessee, it is a capital lease. This criterion is not controversial and easily implemented in practice.

2. What are two differences in the financial statement if a lease is recorded as a capital lease instead of an operating lease?

Capital Lease: A lessee would account for a capital lease as an asset and an obligation at the inception of the lease. Rental payments during the year would be allocated between a reduction in the liability and interest expense. The asset would be amortized in a manner consistent with the lessee’s normal depreciation policy for owned assets, except that in some circumstances, the period of amortization would be the lease term.

Operating lease:

No asset or liability would be recorded at the inception of the lease. Rental on an operating lease wouldbe charged to expense over the lease term as it becomes payable. If rental payments are not made on a straight-line basis, rental expense would be recognized on a straight-line basis.

3. Select an industry and assume you are an owner of a business in that industry. Share the industry you selected and discuss which would you prefer and why: operating lease or capital lease. Please support your choice

Telecom Industry.

The performance in telecom Industry is measured through the performance of EBITDA (earnings before, interest, tax, depreciation & amortisation).

In capital leases, ental payments during the year are allocated between Interest expense and depreciation expense, hence goes below EBITDA, whereas in operating leases, Rental on an operating lease would be charged to expense over the lease term which impacts EBITDA margins.

Hence, it is preferred to show the Telecom towers taken on leases as a capital lease so it will show the improved EBITDA for a telecom company,.