Financial modelling - Need to Know Lease adjustment

Financial modelling is an art to represent financials of companies in meaningful manner. It helps to analysis company performance based on various factors such as profitability, liquidity analysis, cost benefit analysis. It also use to project future cash flow of the company and valuing company. In the process of valuation lease play an important part, today we are discussing that.

In financial modeling training, we explain how to adjust lease in Enterprise value calculation.

A lease is an authorized agreement in which the owner of an asset rent to a lessee. We examine long-term leases in which the lessee lives with the asset till the term of the agreement.

 In financial terms, the leases are considered as alternatives to purchasing an asset with debt, and leases act as an income for the lessee.

 Regardless of how the asset is held, the operating inflows and outflows from the equipment are unaffected by its ownership. The owner handles the responsibility for maintaining the equipment. 

According to Financial Accounting Standards Board, The lease is considering all of the benefits and risks incident to the ownership of the property to the lessee. 

It is assumed that the lessor pays taxes on the income for the lease rentals and gets a tax shield on the depreciation of the asset and that can be claimed as an expense by the lessee. The analysis assumes that the tax authorities treat the lessor as the owner of the asset and the lessee as the user.

Capital Lease vs Operating Lease

Capital and operating leases are subject to the different accounting treatments for both the lessee and the lessor. For entry-level finance interviews, it is enough to understand the accounting treatment for the lessee only.

Accounting for an operating lease is relatively straightforward. Lease payments are categorized as operating expenses and are deducted from earnings. The firm does not own the asset, therefore, it does not show up on the balance sheet, and the firm does not assess any depreciation for the asset.

A capital lease entails the transfer of asset ownership rights to the lessee. The lease is considered a loan, and interest payments are expensed on the income statement.

The asset's present market value is included on the assets side of the balance sheet, and depreciation is levied on the income statement. On the other hand, liabilities include the loan amount, which is the net present value of all future payments.

Both capital and operating leases are commonly used by companies, it is important to gain an understanding of accounting. Each lease has its advantages. Depending on the company's demands and tax situation, they may choose one or the other, or even a combination of the two, for different sorts of assets.

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