There are two basic forms of leases: operating and capital leases. An operating
ID: 2735035 • Letter: T
Question
There are two basic forms of leases: operating and capital leases. An operating lease involves only the right to use an asset for a period of time, where the asset is returned at the termination of the lease. With a capital lease, the lessee usually makes arrangements with the lessor with an option to acquire the asset at the end of the lease period. Because capital leases must be reflected on the balance sheet or statement of financial position, there has been a tendency for companies to simply classify all leases as operating, as this would allow them to defer expenses and report a lower debt amount. Such actions are often referred to as off-balance sheet reporting and can materially misrepresent the financial position of a company. The development of IAS 17 has created guidelines for determining how to classify and report a lease and reduce the amount of controversy involved. The intent is to stop off-balance sheet techniques for lease accounting to provide stakeholders with a more accurate representation of a company's financial position. Once published, these new leasing rules will have a major impact on many companies.
Write a paper comparing capital and operating leases (similarities and differences) and explain how each are classified on financial statements. Explain how their classification and the changes in how they were reported over time impacted accounting practice.
Explanation / Answer
As we all know that there are kinds of accounting methods for leases
(1) operating leases
(2) capital leases
In the market we can see that majority are operating leases. An operating lease is treated like renting -- payments are considered operating expenses and the asset being leased stays off the balance sheet. As against to these capital lease is like a loan; the asset is treated as being owned by the lessee so it stays on the Balance sheet
We can compare the Capital lease and operating Lease as follow
1 In the capital lease , ownership of the asset might be transferred to the lessee at the end of the lease term. As against to these in the operating lease ownership is retained by the lesser during and after the lease term
2 In the capital Lease ,Lessee have an option to buy the equipment at less than fair market value. Operating lease cannot contain a bargain purchase option.
3 In the capital lease term equals or exceeds 75% of the asset's estimated useful life and on the other way ,in operating lease term is less than 75 percent of the estimated economic life of the equipment
4 In the operating lease, The present value of lease payments is less than 90 percent of the equipment's fair market value. As against to this in the capital lease ,the present value of the lease payments equals or exceeds 90% of the total original cost of the equipment.
5 In the capital lease ,Risk and benefits are transferred to lessee. Lessee pays maintenance, insurance and taxes and in operating lease , lessee have right to use only. the risk and benefits remain with lessor. He pays maintenance costs
explain how each are classified on financial statements
Accounting effect
Capital lease is considered as asset (leased asset) and liability (lease payments). Payments are shown in Balance sheet. Operating lease have no risk of ownership. Payments are considered as operating expenses and shown in Profit and Loss statement
Tax effect
In the capital lease, Lessee is considered to be the owner of the equipment and therefore claims depreciation expense and interest expense. As against to this in operating lease, Lessee is considered to be renting the equipment and therefore the lease payment is considered to be a rental expense