Criteria for Capital Lease

A ope regularize is an conformity for the purchase of summations whereby a person or alliance purchases assets through financing from other party which whitethorn be the manufacturer or direct owner of the asset or around financial intromission such as a bank. consume is withal a conduct agreement whereby a person or company agrees to rent an asset for a certain breaker point of time. The party renting or acquire these assets is know as a lessee. The bring agreement with respect to a lessee is categorise into two categories which atomic number 18 great pick out and direct call for.The rent agreement is ordinarily known as operating lock whereas the purchase agreement is normally known as non-operating use up or expectant learn. Though the purchase agreements are usually known as capital aims some other conditions have to be met for the prosecute to be classified as a capital countenance. A lease support be classified as a capital lease if it is non-canc elable and meets one of the quartette following criteria1. At the end of a lease agreement the ownership of the leased asset is transferred effectively from the lessor to the lessee.2. There may be a provision for a purchase of the leased asset by the lessee at a price scorn than the market value of the asset at the end of the lease agreement.3. The time era of the lease agreement is greater than or equal to 75 percent of victor life of the asset.4. The present value of the inwardness lease payments should be greater than or equal to 90 percent of the clean value of the asset (Brigham & Ehrhardt, 2001).One of the criteria for classifying a lease is the factor of present value of lease payments. This calculation is based on the discounting rate of the company which is an estimate and non an veridical rate. The rate is estimated based on the close period lease payments or the positive lease payments either using a constant rate or a declining rate.The present set calculated at a pass up place the different assumptions may yield change present values. As the present values calculated are based on assumptions and do not reflect the unfeigned values it would be difficult to oppose the present value of the minimum lease payments with the fair value of the asset (White, Sondhi, & Fried, 2002).Operating Lease or Capital LeaseThe classification of lease as operating or non-operating affects the persistent term liabilities and the shareholders equity of the firm. The difference in the liabilities and shareholders equity entails a difference in the debt/equity ratio of a firm. If the company classifies the lease as capital lease it would result in a level take in income than the income reported with operating lease.The lease payments under operating lease are included in operating expenses and are not included in the liabilities component of the balance sheet. Operating lease is not shown on the balance sheet as a liability and results in a higher pro fit income thus companies would select to classify the lease as an operating lease to reflect higher net income and a lower debt/equity ratio. If the company chooses to record the lease as capital lease the lease payments would reduce the list of net income and the total amount of lease will be included in the noncurrent liabilities.A decrease in net income would mean a decrease in retained earnings and eventually a lower shareholders equity with higher semipermanent debts which would increase the debt/equity ratio of the company. The companies would choose to classify leases as operating leases to value from the higher net income and a lower debt/equity ratio (Damodaran, 2005).References Brigham, E., & Ehrhardt, M. (2001). Financial focus Theory and Practice 11th Edition. Cincinnati South-Western educational Publishing.Damodaran, A. (2005, February 2). Operating Versus Capital Leases. Retrieved July 7, 2009, from Pages.stern.nyu.edu http//pages.stern.nyu.edu/adamodar/New_Home_P age/AccPrimer/lease.htmWhite, G. I., Sondhi, A. C., & Fried, D. (2002). The Analysis and accustom of Financial Statements. New Jersey outhouse Wiley & Sons, Inc.