Criteria for Capital Lease

A strike is an organization for the grease ones palms of summations whereby a person or friendship purchases assets through financing from an other(a) party which may be the manufacturer or luff owner of the asset or some financial institution such as a bank.Lease is also a rent agreement whereby a person or company agrees to rent an asset for a certain(a) period of time. The party renting or purchasing these assets is known as a lessee. The enlist agreement with respect to a lessee is classified into deuce categories which ar capital lease and operating lease.The rent agreement is unremarkably known as operating lease whereas the purchase agreement is unremarkably known as non-operating lease or capital lease. Though the purchase agreements are usually known as capital leases some other conditions have to be met for the lease to be classified as a capital lease. A lease can be classified as a capital lease if it is non-cancelable and meets one of the four following crite ria1. 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 wrong lower than the market range of the asset at the end of the lease agreement.3. The time duration of the lease agreement is greater than or partake to 75 part of original life of the asset.4. The introduce value of the quantity lease payments should be greater than or equal to 90 percent of the fair value of the asset (Brigham & Ehrhardt, 2001).One of the criteria for sort outing a lease is the factor of indue value of lease payments. This calculation is based on the discounting rate of the company which is an estimate and not an actual rate. The rate is estimated based on the close period lease payments or the add lease payments either exploitation a constant rate or a declining rate.The present set calculated under the different assumptions may yield varyin g present values. As the present values calculated are based on assumptions and do not reflect the actual values it would be uncorrectable to compare 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 long term liabilities and the shareholders faithfulness 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 lower cabbage 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 section of the balance sheet. Operating lease is not shown on the balance sheet as a financial obligation and results in a higher(prenominal) net income thus companies would prefer to clas sify 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 amount of net income and the total amount of lease will be included in the obsolete liabilities.A decrease in net income would mean a decrease in retained earnings and eventually a lower shareholders equity with higher long-term debts which would increase the debt/equity ratio of the company. The companies would prefer to classify leases as operating leases to benefit from the higher net income and a lower debt/equity ratio (Damodaran, 2005).References Brigham, E., & Ehrhardt, M. (2001). Financial Management 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_Page/AccPrimer/lease.htmWhite, G. I., Sondhi, A . C., & Fried, D. (2002). The Analysis and Use of Financial Statements. New island of Jersey John Wiley & Sons, Inc.