c: Discuss the factors that determine whether a company would tend to favor capital or operating leases.
The incentives for structuring a lease as an operating leaseare:
1.    Tax benefits: If the lessee is in a low tax bracket and the lessor is in a high tax bracket, then leasing the asset allows the lessor to retain the greater tax benefits from owning the asset (e.g., the lessor benefits from using accelerated depreciation on their tax returns).
2.    Leasing the asset with an operating lease avoids recognition of the debt on the lessee's balance sheet. Having less assets and liabilities on the balance sheet than would exist if the asset were purchased increases profitability ratios (e.g., return on assets) and decreases leverage ratios (e.g., the debt to equity ratio).
The incentives for structuring a lease as a capital leaseis that the lessor will have earlier recognition of revenue and income by reporting a completed sale even though the substance of the transaction is similar to an installment sale or financing. The lessor will have higher profitability and turnover ratios. It is important for the analyst to be able to determine whether the accounting treatment of a lease adequately portrays the transfer of the risks and benefits of the leased property and whether the earnings process is complete.
d: Distinguish between a sales-type lease and a direct-financing lease.
Operating leases are just one example of contractual obligations that are not recognized as liabilities on the balance sheet. All financial statements should be adjusted to reflect the economic reality of off-balance sheet financing activities.
Other examples of off-balance sheet financing are:

  1. Take-or-pay and throughput arrangements: Under these contracts, the purchasing firm commits to buy a minimum quantity of an input (usually a raw material) over a specified period of time. Prices may be fixed or related to market prices. Neither the asset nor the debt related to these contracts is recognized in the balance sheet. However, the purchaser must disclose the nature and minimum required payments in footnotes. The analyst can use this information to increase the debt and increase the debt-to-equity ratio of the firm that has such off-balance sheet debt.

  2. Sale of receivables: A firm may sell the receivables to unrelated parties but the firm continues to service the original receivables and transfers any collections to the new owner of those receivables. Although such transactions are recorded as a sale, thereby decreasing accounts receivable and increasing CFO, the buyer usually has limited exposure (the risk of not collecting a receivable is born by the seller). Therefore, the transaction is nothing more than a collateralized borrowing