What are the advantage and disadvantages of converting from an operating lease to finance lease?

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Permalink Reply by Rahul on July 12, 2010 at 10:07am

Finance leases require initial high capital commitments and in industries where technology is fast changing, operating leases are preferred as you can renew your contract based on your requirement. so, operating leases do not burden your Balance Sheet.

Sometimes, operating leases are secured against some assets which restricts the business operations to some extent which is not the case with finance leases. One issue with operating lease is you cannot modify the asset accordingly to your business requirement but can definitely do so with finance lease where you own the asset

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Permalink Reply by Eliecer Campos Cardenas on July 12, 2010 at 10:39am

Adicionalmente existe una ventaja impositiva, ya que en algunos países se permite la deducción total de la cuota a pagar por el arrendamiento financiero. Obviamente, la cuota incluye capital e intereses, lo que hace atractivo y menor pago de impuestos.

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Permalink Reply by john mungai on July 13, 2010 at 7:45pm

Additionally, Financial lease creates initially higher expenses ( through depreciation and interest expense) as compared to operating lease. Therefore, operating lease eases the solvency pressures off-the balance sheet. However, over time, the depreciation charges and interest expense reduce compared to operating lease expense (reverse).
Depending on country`s reporting standards, you can not choose arbitrary which method to use. basically, you use Financial lease if:
1. present value of lease payments are more than 90% of fair value of the asset
2.theres an option to buy off the asset at a discount
3.the lease term is 75% or more of useful life of the asset
4. ownership of the leased aset transfers to lessee at end of the lease.
in summary, you are required to adopt finanicial lease if you have an economical motive to own the asset (but are just simply borrowing money to buy the asset).

I hope the above clarifies this from a financial point of view.

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Permalink Reply by Max Solano on July 12, 2010 at 2:26pm

Hello: The advantages and disadvantages of converting an operating to financial leasing should be evaluated within the legal and financial framework, the country where it operates. From the legal perspective, usually the advantage is that the interest paid can deduct from income tax as a financial cost, therefore becomes a tax shield.
From a financial standpoint, the disadvantage of taking a financial leasing is that it increases the degree of financial leverage as well as records the portion of its assets and simultaneously records the financial commitment on the liabilities side.

Hola: Las ventajas y desventajas de convertir un contrato de arrendamiento operativo en financiero se debe evaluar dentro del marco legal y financiero, del país donde opera. Desde la perspectiva legal, generalmente la ventaja es que el interés pagado en cada cuota permite deducir del Impuesto Sobre la Renta , como un coste financiero, consecuentemente se convierte en un escudo fiscal.
Desde el punto de vista financiero, la desventaja de tomar un arrendamiento financiero es que aumenta el grado de palanca financiera dado que registra el bien como parte de sus activos y al mismo tiempo registra el compromiso financiero en el lado del pasivo.

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Permalink Reply by Derek Ngoga on July 14, 2010 at 12:28am

Fundamentally there may be little difference between the two when gauging advantages or disadvantages, however, with finance leases depending on the tax regime of your country, would incur higher deferred tax liabilities and expense thus affecting the bottom line of the organisation, if the tax allowances on assets is higher than the depreciation rate applied in the finance lease.

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Permalink Reply by Shibu Mathew on July 14, 2010 at 2:27am

As per IAS 17, there are the condition which determine whether the lease is operating or financial lease, the condition has been mentioned in some other reply to you. If the lease is for the major life of asset, then this will be a finance lease and should appear in your balance sheet

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Permalink Reply by Richard Starkey on July 14, 2010 at 6:28am

Hi, assuming reporting under IFRS you need to be guided by IAS17 and cannot necessarily just choose to change.

This has been the point of much manipulation of financial statements in the past. In essence by classifying a finance lease as an operating lease you effectively take the asset and the corresponding liability "off balance sheet".

It also manipulates your operating expenses, as the expense that goes through on a finance lease is
split between depreciation (either cost of sales or operating costs) and interest on liability (finance costs), whereas the rental expense fon an operating lease is classified purely as operating (or cost of sales).

Financial analysts would normally add the future minimum lease payments of operating leases back to the balance sheet to get a more realistic picture of the entities obligations.

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Permalink Reply by Teresa S Dapo on August 10, 2010 at 9:19pm

Matthew, is this a finance lease where the business is into rent-to-own of house and lots, and the contract to sell includes the foll?

A. monthly rent,
B. term of payment of monthly rent
C. interest and
D. penalty charges on late payments of monthly rent

At the end of the term (usually, the term is 15 years), the property (house and lot) is deemed sold
for an additional USD1,000.00 to execute transfer of property to the tenant.

Can you please assist me with the accounting entries (on the books of the lessor) upon:

A. Upon signing of the "Contract to Sell

Assuming that the monthly rent : USD 500

Interest : 18%

: Therefore, monthly rent of USD 500 is principal
plus interest.

Term : 15 years

Penalty on late payments : 2 %


B. Payment of Monthly Rent

C. Payment of USD1,000 at
end of term

D. Transfer of property
to tenant/buyer

Other questions:

1. In this kind of arrangement, does the lessor records depreciation?

2. Does the lessor derecognize the property upon signing of the contract?


Can you please assist me understand this?

Thank you very much,
Teresa

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Permalink Reply by Ashwin on August 2, 2010 at 2:01am

If Company is operating with operating lease than financial lease then

Better Debt to Equity ratio

Better Interest coverage ratio

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Permalink Reply by byddu rao on August 21, 2010 at 1:58pm

hi,
conversion from operating to finance lease:

Adv: profit is increased, rentals payment(applicable for operating lease) will not form part in your expenses except the interest(applicable for finance lease- interest & capital payments) to be paid for the finance lease. However, the interest payment be ignored because such amounts are too small compared to the rental payments.

Disadv: The ROCE( return on capital employed) will decrease. Going for finance lease, the leased asset has to be classified as your asset in SFP. As such your liabilities (current & non current) also will become bigger since you owe for the asset.

If performance is remunerated for higher ROCE, better go for operating lease and if directors persist for higher net profits, finance lease can be opted.

Choice is yours.

Thanks

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Permalink Reply by Vitun Sharma on September 9, 2010 at 9:12am

Hello

This is a commonly misunderstood subject. As such I have to first clarify a couple things. A lease may or may not result in an on balance sheet fixed asset.

FAS 13 section 7 is clear on when a lease is a Capital Lease (on balance sheet fixed asset) and when a lease is an operating lease (off balance sheet expensed obligation).

With this in mind your question really has two parts.

1) Pros and Cons of financing an item vs. outright purchase (I assume you mean pay cash) of an item.
2) In the case of financing, pros and cons of an operating lease vs. a capital lease.

So for one:
Pros:
Save cash for more lucrative investments or to sure up liquidity.
Cash management (match cash inflows with cash outflows)

Cons:
You’ll pay more over time (interest).
There can be any number of strings attached when you borrow money, so some loss of freedom.
It adds a bit more administrative overhead for a company to manage financing arrangements.

For two:
Pros:
They may be useful in achieving a desired “look” to the balance sheet as operating leases are not recorded there.
Limited risk of ownership (obsolescence, cease to require the item for operations, etc) as a company may return the item at the end of the lease.
A company won’t have the administrative burden of having to sell off assets as they become obsolete or unneeded as again the item may be returned at the end of the lease.

Cons:
Usually more expensive (the pros to the lessee are all risks to the lessor).
Usually have many strings attached. It takes a real expert to understand the true cost of an operating lease. You must forecast usage and understand the buyout clause up front so you really know how much money you are leaving on the table if you walk away at the end of the lease.

Hope this helps,
Thanks
Business Analysis

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