i never understood why when payment is the same, the total expense would be higher in finance lease at the beginning years, i know the breakdown of principal and interest, and depreciation, but when are those difference counted? BS? or IS? so if they are difference, where does the difference go, I have 2300 outflow of cash but my total expense is 2500 how do I explain the 200 ? I just got really confused
Let’s say that your cash outflow is $2,300, your interest is $1,300, your principal is $1,000, and your depreciation is $1,200.
So assets are less by $3,500 ($2,300 in cash, $1,200 in depreciation), your liabilities are less by $1,000 (principal), and your net income (and, therefore, equity) is less by $2,500 ($1,300 in interest expense, $1,200 in depreciation).
With the operating lease, your assets would be less by $2,300, and your equity would be less by $2,300.
The $200 difference is in net income, then in equity.
No numbers concept:
For the finance lease, you start off with an equally sized Asset and Liability. Both will end up at zero by the end of the lease, but they approach zero at different speeds.
The Asset decreases straightline. But the laibility decreases just like a mortgage balance - very slowly then very quickly.
Fixed those for you.
This is because the interest part in monthly (annualy or quarterly) annuity is larger than principal part during the first period of amortizing loan (consider finance lease as ordinary loan).
Also, there is a depreciation expense of asset which is formally and legally under the ownership of lessee.
This is not such situation with operating leases (consider it as ordinary rent), lessee pays monthly (annualy or quaterly) rent for using an asset and in monthly rent payment is included depreciation cost of asset by lessor side as well as a lease charge ( a lessor’s mark up). Since, in general, by operating lease those rent payments from lessee to lessor are evenly distributed through whole contract period, the monthly expenses by operating leases are smoother thus lower during the first period (years) of lease contract.
S2, no need to fix, I was just trying to illustrate the basic concept.
Your ‘correction’ above is imperfect as well. Introducing salvage value to a capital lease is a complicating factor. This means it is time to start reading the terms of the lease contract. This guy neds to start with basic concepts, IMO.
CFA Institute has questions about capital leases that include salvage value. It’s a complicating factor, but a necessary one.
C’mon, striking through text is fun.
I haven’t reviewed the lease cirriculum, yet. Salvage value for the lessee inplies that they keep the property at the end of the lease. H21, I’d recommend getting comfortable with the basics before moving on to more advanced examples. Cyprus, hahaha. That looks like one if my memos after my boss gets through with it.
It doesn’t imply anything of the sort. There’s a final payment, like the balloon payment on a loan that isn’t fully amortized. If the lessee keeps the asset, they make that payment to the lessor. If they return the asset to the lessor, they have to make up any difference between the salvage value and the market price.
Level I candidates had salvage value when computing depreciation; this is nothing new to the Level II candidates.
I never estimate salvage value for any asset in real life. Everything is targeted on 0,00 BV after depreciation expiring. Also I don’t know anybody who estimates SV.
Except, of course, CFA Institute.
Poor h21 probably wishes he had never asked the quesiton - purchase options with ballon payments at the end…
I think that both salvage value and non-straightline depreciation are more common in textbooks than in practice.
And more common on the CFA exams than in practice.
But that’s what we’re discussing.
Acellerated depreciation makes sense if it is permited by law due to tax savings. Unfortunately in my country it isn’t. I mean DDB.
What about units-of-activity?
Nope, only linear is mandatory for both accounting and tax purpose. Entity may use prescribed accelerated rates for each asset class but only in linear mode. I use units-of-activity only for internal reporting purpose in simulations.
Here in the US, tax and book depreciation are independent of each other. Fixed Asset systems need to be able to track assets for different reporting reporting purposes (GAAP, Stat/Regulatory reporting depending on industry, tax). Our tax code may be more politicized than some other places, though.
I know. I am doing business for US entity branches. The good side of our tax system is in simplicity and in statutory CIT rate of exact 20 % for all entities which has not changed for 20 years. The bad side, personal income taxes are progressive, ther are also mandatory pension and health contributions for employeer to pay to each employee and labor is very expensive. Good thing, we have plenty of paid free days and vacations.
Your system sounds pretty reasonable. Here in the US, employers pay a contribution to the government for employee pension and medical (Social Security and Medicare), as well. Many also pay separately towards retirement and private health insurance for their employees. A couple years ago, it became mandatory for companies to report on employee tax forms the amount they contribute towards private health insurance. My employer paid $20,000 towards my insurance in 2015, which covers me, my wife and my kids, That is more than I pay for my mortgage. It is kind of crazy, and a significant burden on businsesses.