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Can you please help me to site the advantage and disadvantages of converting from an operating lease to finance lease?

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Topic Expert
Barrett Peterson
Title: Senior Manager, Actg Stnds & Analysis
Company: TTX
(Senior Manager, Actg Stnds & Analysis, TTX) |

I am not sure there is a clear "advantage". All leases are financing transactions which incur a legally enforceable debt [except in bankruptcy]. The principal perceived advantage of operating lease treatment is the reporting of annual expense based on annual cash payments. The principal negative is the obscuring of the debt outstanding [required in the footnotes], and the assets employed to operate the business. A finance lease corrects the operating lease negatives by reporting the asset and the debt, with the principal perceived disadvantage the disconnection of reported expense and cash paid under the lease. For finance lease, annual expense is for depreciation on the asset, usually straight line, and interest on the debt, invariably declining. Total expense is higher in the early years of a lease.

Some entities may find finance lease treatment attractive despite the higher early year expense aspect as the "operations" expense is lower [rent expense includes a financing component], with more"interest" expense which can favorably impact certain bonus calculations, compliance covenants, and the like.

The accounting treatments have perceived pluses and minuses, as do the effects/implications, not always favoring the same result. Not an easy comparison. Economic reality is that leases are a financing transaction.

John Kirk
Title: Managing Director
Company: Lease Portfolio Recovery Services
(Managing Director, Lease Portfolio Recovery Services) |

There a few additional considerations regarding financial risk which are specific to equipment leasing and that a comparison of capital versus operating lease options should include. The comparison is usually not a simple and straight forward exercise. The devil in these arrangements is in the details.
Both operating leases and capital leases frequently contain terms and conditions which drive additional costs beyond the committed rent stream. Some of these are related specifically to the operating lease structure such the FMV definition at end of lease. However there are ”capital” leases which contain options at end of lease which may generate FMV related risk as well. More broadly all equipment leases potentially contain terms and conditions related to notice, up front interim rent, default triggers and other risk factors which should be considered in a comparison of lease options.
Lessors of equipment make a large amount of money on extension payments. TRUE capital leases – with tightly defined language which provides for ownership at end of term – are lower risk than typical operating leases. However there are many “capital” leases which also contain significant financial risk.
The rate and rent stream are only one consideration. Look at the other terms and conditions to determine if your operations can realize the potential benefits of equipment finance.

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