In comparing capital leasing with operating leasing, an answer to a problem states that: “For the lessee, the current ratio would be lower under a capital lease because the current portion of the lease payment (current liability) is recognized, while there is no balance sheet impact for an operating lease.” Is this correct? Are they saying that the amount by which you amortize the lease liability is considered a current liability? I’m not sure how exactly booking for this goes, but if they are saying that a liability in the amount of the amortization exists, then wouldn’t that liability gets wiped out once the actual periodic payment of the lease occurs? That is, if the lease payment is made at end of quarter, would there still be a current liability? In short, explain the quoted text above, please.
Balance sheets are classified between current and non-current liabilities (and assets). If you have a liability with annual amortization (ie payments), at each balance sheet date the portion due within the next year will be shown as a current liability, reducing working capital and the current ratio. Period costs (ie future rent payments) don’t hit the balance sheet in advance so they don’t have the same effect on the ratios.
Super I, that’s interesting. What happens to the matching principle? Shouldn’t the amortization of the lease liability (which is only part of the lease payment by the way) be recognized when it is incurred? So, why record next year’s liability today? And if that’s the case, then you should do the same at the inception of the lease, which I am not sure I have seen it done before.
Dreary, I’m really only talking about capitla leases. Of course you record the entire liability upfront, at the same time that you record the asset. It’s just that you split out the part that will bepaid down in the next 12 month and show it as current, and the balance as long-term, the same way you would with any other kind of debt on your books. Matching refers (primarily) to revenue/expense concepts. “amortization of the llease liability” refers to paydown of a balance sheet item and that is where the current non-current comes in.
I’m not clear what you’re saying when talking about amortizing liabilities. Your current liabilities in a cap lease are broken out between interest payable and lease payable sum of which equals 12 months of your lease payment In an operating lease, you will only accrue a current liabilitiy as you use the property, so after a month, you’ll accrue 1/12th of the annual rent expense.
The point is that I want to clarify why the current ratio (CA/CL) would be lower under a capital lease? * Current assets are not affected, right? Long-term assets go up, but current ones are the same. * What about current liabilities? Long-term liabilities increase, but that’s not relevant in calculating the current ratio. It is explained (by at least one source) that current liabilities increase due to the current portion of the lease liability. Fine, but on Dec 31st, the firm will have paid the lease payment and there is no current liability, so why does current ratio go down? Super I suggests that the current liability is recorded upfront, so on Dec 31st a fresh new liability for the next year is added. If so, then that explains things, but I am not familiar with this kind accounting treatment, i…e, you can’t book a liability for something you haven’t yet used.
In Dec, just as Super I says, the Current Liability (which is the portion to be paid during the next full year) is brought in, and the Long Term Liability would become the remaining portion. So CL would go up, and the Current Ratio would be reduced. CP
Dreary, You have to think about the fundamental diff between capital and operating leases. Operating lease in substance is "hey I want to rent that thing’. You don’t own it, and as you use you pay for and record rent expense. At year end there is either no liability, or if you forgot to drop the Dec check in the mail you record the account payable as the offset to the month’s expense instead of cash. capital lease is in substance “hey I want to own that thing, but can you finance it (ie lend me the money to buy it) and let me pay it off over time”. It’s no fresh new liability. Think of buying a house and taking out a 30-year mortgage. That’s pretty much what a capital lease looks like. You have at close long-term debt, but instead of showing it in one line, you always split out the next 12 payments (principal portion) on a line as current liabilities. I hope this helps because I really can’t make it any clearer
There are no accounting entires I could find in the study material to show the booking in advance as you are saying (I believe you, I just need to verify it for myself). In similiar situations found in the study material, like when a firm issues bonds, interest payable (i.e. coupon payment) is recorded only after it is incurred. That is, if you issue bonds on Jan 1st, no interest expense (coupon payments) is booked or paid, until end of 1st quarter. Only then do you book one quarter’s worth of interest (no paymnet yet). In the way you are describing it, you are effectively saying that on Jan 1st, the coupon payment for the full year (assuming annual bonds) is recorded as a liability. Again, I just need to see how current ratio decreases under capital leasing.
I’m not sure I understand. You need to verify that the current portion of the lease obligation impacts short term (current) liabilities, thus impacting the current ratio? I guess you can look at page 522 in the CFAI text. It shows the balance sheet impact of a lease. Reference the liabilites section and you’ll see a line item for the Current Portion of the Lease Obligation broken out.
Thanks for the pointer, that’s what I was looking for. Yes, it seems that the principlal payment on the liability is booked in advance, yet I am still confused as I believe this is not what’s done with bonds, could someone verify? Thanks Shabadoo1, Super I, cpk123, and others.
You know, I don’t recall reading it explicitly in any of the texts with regard to bonds, but I would think that the principle payments due in the next 12 months would probably be current liabilities. I think it isn’t hit on in the texts in the same way as with leases since you’re comparing capital vs operating leases and in that context seeing how the balance sheet is different in both scenarios. With bonds those differences really aren’t there as you have to hit liab. vs expenses. Someone can correct me as that is a bit of an assumption.
Guys, this is not rocket science. You borrow $500, due in 5 equal annual installments Debit cash $500 Credit Long term debt $500 On the balance sheet in year 1 you will show the principal portion due within the next 12 months (ie payment 1) as current portion of LTD $100, and rest as LTD$400 A year passes and of the remaining $400 due you show the principal portion due within the next 12 months (ie payment 2) as current portion of LTD $100, and rest as LTD$300 and so on. The interest is recorded as accrued, and paid whenever the terms of the loan says it is paid. Pick your favorite big company, go to its website, click on investor relations, click on SEC filings, open the last 10-K, look at the balance sheet and read the accompanying footnotes. Stop dikking around with textbook explanations of presentation when you can look at real life examples.
Super I, I think you’re wrong… rocket science is a little easier than reading 6 big volumes of various disciplines!
The value of decrease in Current Liabilities would equal the amount of depreciation on the leased asset for the current year, right?
For Capital Leases, The value of decrease in Current Liabilities would equal the amount of depreciation on the leased asset for the current year, right?
nahsuar Wrote: ------------------------------------------------------- > For Capital Leases, > The value of decrease in Current Liabilities would > equal the amount of depreciation on the leased > asset for the current year, right? No. Your liability amortizes the way the debt amortizes based on the payment terms. Depreciation is calculated the normal way depeciation is calculated. There is no direct linkage.
That makes sense, Thank SI.