A capital lease (now referred to as a finance lease under IFRS 16 and ASC 842) is a leasing arrangement where an organization records the leased asset and liability on its balance sheet as if it were owned. Organizations enter into capital leases to improve financial metrics, including free cash flow from operations.
Let’s analyze each option:
Option A: To increase the ability to borrow additional funds from creditors
Incorrect. A capital lease creates a liability on the balance sheet, which may reduce borrowing capacity rather than increase it.
Option B: To reduce the organization ' s free cash flow from operations
Incorrect.
Operating leases impact operating cash flow because lease payments are treated as operating expenses.
Capital leases (finance leases) shift payments to financing activities, improving operating cash flow since lease obligations are classified as debt.
Option C: To improve the organization ' s free cash flow from operations
Correct.
Capital lease payments are classified under financing activities rather than operating activities, which increases free cash flow from operations.
This improves financial ratios and liquidity metrics, making the organization appear more attractive to investors.
IIA Reference: Internal auditors assess lease accounting and financial reporting impacts under IFRS 16 (Leases) and ASC 842 (Leases). (IIA Practice Guide: Auditing Financial Reporting Risks)
Option D: To acquire the asset at the end of the lease period at a price lower than the fair market value
Incorrect. While some capital leases include a bargain purchase option, the primary reason for entering into a capital lease is financial reporting benefits, not necessarily acquiring the asset.
Thus, the verified answer is C. To improve the organization ' s free cash flow from operations.
