To lease or not to lease?

By Simon Wang on August 18 2010

Over the course of reviewing and rebuilding many models, I have encountered an unusual number of errors involving Capital Leases and Operating Leases. Capital Leases are also known as Finance Leases in different parts of the world. These issues are often

not picked up correctly in the model
mistaken for each other
incorrectly treated in the financial statements

When to use a Capital Lease in a financial model

Avoiding technical accounting details, a capital lease is
“… a commercial arrangement where an asset is borrowed from a company for most of its useful life. A series of payments is made for borrowing the asset and at the end of the arrangement there is an option to own the asset.” A capital lease allows you to avoid making large down payments for purchases of equipment, providing more flexibility in managing your cashflow. Common examples of capital leases include longwall mining machinery, freight ships and bucket-wheel excavators.

When are Operating Leases used in project financings?

These are normally used to acquire assets for short term use compared to the useful life of the asset. There is only a transfer of rights to use the asset. Common examples of operating leases include computers and office equipment.

Why are there different types of leases?

The main reason for a capital lease (financing lease) and operating lease is their different treatments in the financial statements and the underlying motivations.

Capital leases, as the name implies, are capitalised on the balance sheet, increasing your asset and liabilities (the asset and the lease payments).
Operating leases on the other hand, only consider the payment for lease as an operating expense and does not affect the firm’s capital.

Considerations when modelling a lease for a project financing

Having highlighted the different treatments of a capital lease and operating lease in the financial statements, it is important to differentiate between the two in your modelling. Capital leases are treated as assets and should be included in your depreciation and amortisation calculations. Alternatively, operating leases should only be included in your operating expenses and not be picked up as an asset or depreciated. With the large number of different expenses in a model, you can see how easy it is to get confused and mix them up if you don’t have them correctly categorised!

Modelling tips for leases

The best tip to avoid confusion and errors when modelling capital leases and operating leases is to keep things simple and organised. By following best practice methodology, you should have clearly defined sections in your input sheet that specify capital expenditure items for your capital leases and operating expense items for your operating leases. This lets you pick up all the capital expenditure items which will be capitalised on the balance sheet and depreciated, separate from your operating expenses. (To see how to properly structure your model using best practice principles, join us at our Project Finance Modelling A course).