Criteria for Capital Lease

A demand is an agreement for the acquire of assets whereby a person or company purchases assets through financing from other party which may be the manufacturer or direct 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 period of time. The party undertake or purchasing these assets is known as a lessee. The drive agreement with respect to a lessee is classified into two categories which are detonating device lease and operational lease.The rent agreement is usually known as operational lease whereas the purchase agreement is usually known as non- operational 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 criteria1. At the end of a l ease 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 lower than the market value of the asset at the end of the lease agreement.3. The time date of the lease agreement is greater than or equal to 75 percent of original life of the asset.4. The present value of the total 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 classifying a lease is the factor of present value of lease payments. This calculation is ground on the discounting rate of the company which is an estimate and not an actual rate. The rate is estimated based on the next period lease payments or the total lease payments either using a constant rate or a declining rate.The present values calculated under the different assumptions may yield alter present values. As the present values cal culated are based on assumptions and do not glow the actual values it would be thorny 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 letter LeaseThe classification of lease as operating or non-operating affects the long 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 lower realize 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 winding-clothes. Operating lease is not shown on the balance sheet as a liability and results in a higher net income thus companies would prefer to classify the lease as an operating lease to reflect higher net incom e 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 noncurrent 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 Sta tements. New Jersey John Wiley & Sons, Inc.