The Effect of a Capital Lease on Operating and Net Income

The effect of a capital lease on operating and net income is different than that of an operating lease because capital leases are treated similarly to assets that are purchased; that is, the company is allowed to claim depreciation on the asset and impute an interest payment on the lease as tax deductions rather than the lease payment itself. The imputed interest payment is computed by assuming that the lease payment is a debt payment and by apportioning it between interest and the principal paid.

On the balance sheet, a leased asset is not shown on the balance sheet; in such cases, operating leases are a source of off-balance sheet financing. However, a capital lease is shown as an asset on the balance sheet, with a corresponding liability capturing the present value of the expected lease payments.

Consequently, by converting Cisco’s operating leases to capital leases, they would recognizes both asset and liability for the lease, thereby increasing total liabilities and making the company appear more risky. Converting to capital leases provides a more conservative measure of total liabilities. The operating income, capital, profitability and cash flow measures for Cisco would have to be adjusted. The effects are as follows:

Adjusted lease pmts by year Total 2008 2009 2010 2011 2012 Thereafter

Operating leases Commitment 1,603 252 204 180 156 138 673

Present value @ 8% 1,102 233 175 143 115 94 342

The present value of operating leases is treated and an asset and as the equivalent of debt which is added to the conventional debt of Cisco. The adjustments to the assets