Why do firms

prefer reporting
operating or capital
leases
17181554-012
17181554-007
17181554-027
17181554-050
LEASE:
Lease is a financial arrangement, wherein one party (lessor) allows
another party (lessee) to use the
capital asset or equipment for a definite period, in return for an
adequate consideration, i.e. lease rental
charges In this contract, the lessee need not buy or own the asset in
order to use it, because it is a form
of renting assets.
Parties to A lease is a contractual agreement:
Lease
lessor (Owner of Property) conveys
the right to use property to

lessee (User/Renter) in return for

periodic cash payments

For stated period of time

 CLASSIFICATION OF LEASE
LEASES

LESSEE LESSOR

CAPITAL OPERATING OPERATING CAPITAL

LEASE LEASE LEASE LEASE

transfers rental
ownership agreements DIRECT SALES
FINANCING TYPE

Classification Criteria:…>
4
 CLASSIFICATION OF LEASE
LEASES

PART I PART II
LESSEE LESSOR

CAPITAL OPERATING
LEASE LEASE

transfers rental
ownership agreements

Classification Criteria:…>
5
Operating Lease and Finance or Capital
Lease

Operating Lease: When in a lease contract, the lessor has the right to get
the possession of the asset
back from the lessee, at the end of the lease term, then it is called as an
operating lease.
Finance or Capital Lease

Finance or Capital Lease: When in a lease agreement, lessee retains

the possession of the leased asset
or equipment even after the period expires then such a type of lease is
called as Finance Lease.
 CLASSIFICATION
CLASSIFICATION OF
OF LEASE:LESSEE
LEASE:LESSEE
Lease Agreement MUST MEET JUST ONE
Non-Cancellable
CRITERIA O
p
e
r
a
No No No t
Transfer Bargain Lease Term
PV of i
of Payments No
Ownership Purchase >= 75%
>= 90% n
g

Yes Yes Yes Yes L

e
a
Capital Lease s
e
Determine if the risks/rewards of ownership transferred to lessee
9
Advantages of Capital Lease and Operating Lease

ADVANTAGES OF A CAPITAL LEASE:

There are many advantages to a capital lease, including the following:

Lessee is allowed to claim depreciation on the asset, which reduces taxable
income
Interest expense also reduces taxable income
Advantages of an Operating Lease

There are many advantages to an operating lease as well:

Operating leases provide greater flexibility to companies as they can
replace/update their equipment more often
No risk of obsolescence, as there is no transfer of ownership
Accounting for an operating lease is simpler
Lease payments are tax-deductible
 Difference between capital and operating lease
Capital Lease Operating Lease
Lease criteria - Ownership Ownership of the asset might be transferred to Ownership is retained by the lessor during and
the lessee at the end of the lease term. after the lease term

Lease criteria - Bargain The lease contains a bargain purchase option to The lease cannot contain a bargain purchase
Purchase Option buy the equipment at less than fair market option.
value.

Lease criteria - Term The lease term equals or exceeds 75% of the The lease term is less than 75 percent of the
asset's estimated useful life estimated economic life of the equipment

Lease criteria - Present The present value of the lease payments equals The present value of lease payments is less than
Value or exceeds 90% of the total original cost of the 90 percent of the equipment's fair market value
equipment.
 Difference between capital and operating lease
capital operating
Risks and Benefits Transferred to lessee. Lessee pays maintenance, Right to use only. Risk and benefits remain
insurance and taxes with lessor. Lessee pays maintenance costs

Accounting Lease is considered as asset (leased asset) and No risk of ownership. Payments are
liability (lease payments). Payments are shown considered as operating expenses and shown
in Balance sheet in Profit and Loss statement

Tax Lessee is the owner of the equipment and Lessee is considered to be renting the
therefore claims depreciation expense and equipment and therefore the lease payment is
interest expense considered to be a rental expense
Why do firms prefer reporting operating
or capital leases?

Capital lease:

A capital lease (or finance lease) is treated like an asset on a company’s balance
sheet. Think of a capital lease as more like owning a piece of property .Capital
leases are counted as debt. They depreciate over time and incur interest expense.
To be classified as a capital lease under U.S. GAAP, any one of four
conditions must be met:
Capital leases:
A transfer of ownership of the asset at the end of the term
 An option to purchase the asset at a discounted price at the end of the term
 The term of the lease is greater than or equal to 75% of the useful life of the
asset
 The present value of the lease payments is greater than or equal to 90% of the
asset’s fair
market value.
Example #1

A vehicle has a fair value of $16,000 and a lease term of 3 years. The
monthly payment of lease is $500, out of which $50 relates to
maintenance. The interest rate in the market is 4%. The useful life of
the vehicle is 8 years. At the end of the lease contract, the lessee can
purchase the asset at $1000. What type of lease is this?
Solution
We need to check the basic four criteria to check if it’s a capital lease.

 The ownership is shifted to the lessee at the end of the lease period.

 The lessee can buy an asset at the end of term at a value below market price.

 The lease term comprises at least 75% of the useful life of the asset.

 The present value of the lease payment is 90% of the fair value of the asset at the

beginning.
Detail
There is no title transfer at the end. Neither there is a bargain purchase
option. The lease term is 3 years, while the useful life is 8 years. 3 years is
less than 75% of 8 years, so the three tests for capital lease accounting are
not met. For checking the fourth criteria, we need to calculate the present
value of monthly payments of $450 (excluding maintenance) The present
value* of the lease payment is $15,292, which is greater than 90% of the
fair value of the asset (90% of $16,000 is $14,400). Therefore, it’s a capital
lease.
Detail
Number of months = (3*12) i.e. 36 months

*Present value of minimum lease payment= $15,292

Depreciation= ($16,000/8) i.e. $2,000

Interest for 1st month @ 4% of present value= $50

Lease liability- interest expense= 450-50= $400

Journal Entries

#1 – During the First Month

500
Journal
Entries
#2 – During the 500
Remaining
Months
Example #2
capital lease

The value of machinery is $11,000, and useful life is 7 years. The 

scrap value of the asset at the end of useful life is nil. The monthly
lease payment at the end of each month is $ 200. The lease term was
for 6 years, and the interest rate stood 12%. Pass the journal entries in
books.
Solution: We need to check the basic four
criteria to check if it’s a capital lease.
The ownership is shifted to the lessee at the end of the lease period.
The lessee can buy an asset at the end of term at a value below
market price.
The lease term comprises at least 75% of the useful life of the asset.
The present value of the lease payment is 90% of the fair value of
the asset at the beginning.
There is no title transfer at the end. Neither there is a bargain
purchase option. The lease term is 6 years, while the useful life is 7
years, so the criteria are met here. For checking the fourth criteria, we
need to calculate the present value of monthly payments of $200. The
present value* of the lease payment is $1,033, which is greater than
90% of the fair value of the asset. Therefore, it’s a capital lease.
Number of months = (6*12) i.e. 72 months
*Present value of minimum lease payment= $1,033
Depreciation= ($11,000/7) i.e. $1,571
Interest for 1st month @ 1% of present value= $10
Lease liability- interest expense= 200-10= $190
Journal
Entries 

#1 – During the First

Month
#2 – During the
Remaining
Months

Lease
(Capital Lease with Unguaranteed
Residual Value)
On January 1, 2007, Burke Corporation signed a 5-year noncancelable lease for a machine. The terms of the lease
called for Burke to make annual payments of $8,668 at the beginning of each year, starting January 1, 2007. The
machine has an estimated useful life of 6 years and a $5,000 unguaranteed residual value. Burke uses the straight-
line method of depreciation for all of its plant assets. Burke’s incremental borrowing rate is 10%, and the Lessor’s
implicit rate is unknown.

Instructions

(a) What type of lease is this? Explain.

(b) Compute the present value of the minimum lease payments.

(c) Prepare all journal entries for Burke through Jan. 1, 2008.

LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.
 Accounting by the Lessee
E21-1 What type of lease is this? Explain.

Capital Lease, #3
Capitalization Criteria:
NO
 Transfer of ownership
 Bargain purchase option
 Lease term => 75% of economic
Lease term NO
life of leased property
5 yrs.
 Present value of minimum lease
Economic life
payments => 90% of FMV of
•property F MV of leased
6year s.
Pproperty is unknown.
YES
LO 2 Describe the acco8un3t.i3ng%criteria and procedures

for capitalizing leases by the lessee. 17

 Accounting by the Lessee

E21-1 Compute present value of the minimum lease payments.

Payment $ 8,668
Present value factor (i=10%,n=5) 4.16986
PV of minimum lease payments $36,144

Journal entry
1/1/07 Leased Machine Under Capital Lease 36,144
Leases liability 36,144
Leases liability 8,668
Cash 8,668

LO 2 Describe the accounting criteria and procedures

3
for capitalizing leases by the lessee.
0
 Accounting by the Lessee

E21-1 Lease Amortization Schedule

10%
Lease Interest Reduction Lease
Date Payment Expense in Liability Liability
1/1/07 $ 36,144
1/1/07 $ 8,668 $ 8,668 27,476
12/31/07 8,668 2,748 5,920 21,556
12/31/08 8,668 2,156 6,512 15,044
12/31/09 8,668 1,504 7,164 7,880
12/31/10 8,668 788 7,880 0

LO 2 Describe the accounting criteria and procedures

for capitalizing leases by the lessee. 3
1
 Accounting by the Lessee

E21-1 Journal entries for Burke through Jan. 1, 2008.

Journal entry
12/31/07 Depreciation expense 7,229
Accumulated 7,229
depreciation
($36,144 ÷ 5 = $7,229)

Interest expense 2,748

Interest payable 2,748
[($36,144 – $8,668) X .10]

LO 2 Describe the accounting criteria and procedures

for capitalizing leases by the 32lessee.
 Accounting by the Lessee

E21-1 Journal entries for Burke through Jan. 1, 2008.

Journal entry

1/1/08 Lease liability 5,920

Interest payable 2,748
Cash 8,668

LO 2 Describe the accounting criteria and procedures

for capitalizing leases by the 33lessee.
 Any
questions