a problem about lease

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sunbull

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why using capital lease method resulting in higher EBIT than using operation method?
I think it is maybe the same because the EBIT=sales-COGS-SG&A while the COGS and the SG&A are not influenced by the leasing accounting method .

Who can tell me the thuth??
 
I haven't covered this for a few months, but if I remember correctly I believe that a capital lease is amortized which would lower the amoritzation expense and therefore increase EBIT in the early years, but in the later years I think that an Operating lease will have a higher EBIT than Capitalized.

Like I said, I haven't covered this for at least 4-5 months. I have just started to look over FSA again, so I'm not sure if I am blending different concepts together or not.
 
Capital Lease has two components, one part is interest.

EBIT = Earnings Before Interest & Taxes



Edited 1 time(s). Last edit at Thursday, September 7, 2006 at 09:13AM by killamanjaro.
 
Capitalisation: Here, accounting for the lease is in the form of depreciating the asset. The asset is treated as if it had been bought by the company i.e determining the useful years, the depreciation method and hence the depreciation amount.

Operational: Here, accounting for the lease is in form of the actual lease rental payments made.

In all circumstances lease rentals will always be higher than the depreciation amounts hence lower earnings in operating vs capitalised leases.
 
though, nobody really answer my questions.
 
Your question has been answered.

The charges for both are the same. Except the capital lease is broken into part depreciation and part interest expense. The part that is interest expense is subtracted *AFTER* you calculate EBIT.

Example:

Lease amount = 5,000

Operational Lease = Lease Expense 5,000
Capital Lease = Depreciation Expense 3,000 + Interest Expense 2,000


Operational Lease Method = Revenue 10,000 - Lease Expense 5,000 = EBIT 5,000
Capital Lease Method = Revenue 10,000 - Depreciation Expense 3,000 = EBIT 7,000
 
Sunbull,

If you plan on getting thru L1, there are some topics that you should be able to read up on and figure out yourself. This is one of the more straighforward topics (relatively) you'll see over the 3 levels.

I'll reference White, Sondhi 3rd edition bottom of p.368-369

You have an asset that you are paying $10,000 rent on for 4 years, total $40,000.

If this is an operating lease, your annual expense is $10,000.

If based on the requirements this is deemed to be a capital lease, assuming a 10% discount factor, the present value and amount you capitalize is $31,700. With straight line depreciation your annual depreciation expense is (31,700/4)= $7,925.

Since the $7,925 depreciation expense (capital lease) is LOWER than the $10K rental expense (operating), you end up with a higher EBIT.

Note that I didn't discuss the interest expense component of the capital lease - that is because EBIT, as the name implies is BEFORE interest expense. If you want to to know the different effect on the bottom line between the two, look at the table on the bottom of p.369

(Kili - your answer is a bit too simplified in that it implies that depreciation + interest= lease payment which is not the case. The annual payment reduces your offsettting liability, so you don't have a level total expense equal to the total payment each year under the capital lease approach)

Hope this helps.



Edited 1 time(s). Last edit at Friday, September 8, 2006 at 12:14AM by Super I.
 
Super I:

Yeah, I knew it was simplified. But I thought he would just look it up with a little hint.

By the way, I disagree.

Page 370 -- "Note that total expense (interest plus depreciation) for a capital lease must equal total rental expense for an operating lease over the life of the lease."

1. Leasing is a form of borrowing, why would interest not always be a component??

2. The annual payment depends on the method of depreciation/amortization being used. If straight line then the total expense won't be equal. If another method, then it only makes sense that total expense be equal. SFAS 13 mandates straight line method unless there's a better representation of the use of the property.
 
killamanjaro Wrote:
-------------------------------------------------------
> Super I:
>

> By the way, I disagree.
>
> Page 370 -- "Note that total expense (interest
> plus depreciation) for a capital lease must equal
> total rental expense for an operating lease over
> the life of the lease."
>
> 1. Leasing is a form of borrowing, why would
> interest not always be a component??
>
> 2. The annual payment depends on the method of
> depreciation/amortization being used. If straight
> line then the total expense won't be equal. If
> another method, then it only makes sense that
> total expense be equal. SFAS 13 mandates straight
> line method unless there's a better representation
> of the use of the property.


Kil -

You are absolutely right that over THE LIFE of the lease/asset the toal expense will be the same, its just that in any given year, it is pretty improbable that they would be equal (with SL depreciation for example, at most, this should happen in one year when the the total expense under the two methods "cross over").

I didn't mean to pick on you, but I didn't want someone to assume that the way you calculate interest expense is to PV the lease cash flows for the cost, and then just take the difference between the annual lease payment and depreciation expense to be the interest charge, which given the various level of skills here is a forseeable error using the example you presented.


Re (1) The original question was about the effect of the 2 different accounting methods on EBIT, not the bottom line. EBIT is "earnings BEFORE INTEREST and taxes" therefore interest is NOT a component of this line item on the income statement and the level of interest expense does not affect it. Look back to the bottom of p369 and note how depr is listed as an operating expense and interest is non-operating.

Re (2) as I mentioned above I was referring to individual years, not the total over the life of the lease, which should be the same.



Edited 1 time(s). Last edit at Friday, September 8, 2006 at 01:17AM by Super I.
 
If my memory serves me correctly all of these answers are in the book, do people like to be spoon fed answers?

Capitalized leases are amoritized through interest and depreciated (capital asset). Operating leases are expensed as they are deemed part of the firm's operations if not meeting the criteria for capital leases.

One involves effective transfer of ownership and as the balance sheet carries the debt and the asset there is an amoritization of the liability and a depreciation of the asset causing the different components on the IS. As part of the "lease payment" is interest payment; i.e. part of the amoritization of the liability, then it is listed as interest expense, as there is further delineation of the BS for a capital lease. Once again, operating leases are considering part of the firm's operational expenses and there is no requirement to delineate between the components of the lease and there is definatly no transfer of asset ownership faciliatating the depreciation expense on the IS.
 
I see my mistake.

Balance Sheet vs Income Statement.



Edited 1 time(s). Last edit at Friday, September 8, 2006 at 02:12AM by killamanjaro.
 
Thank you to all of you. The people in the forum are so kind.
 
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