12. Leases Flashcards
Describe operating leases and their basic accounting.
- The lessor transfers only the right to use the property to the lessee and the lessor/owner retains most of the risks and benefits of ownership.
- Lease payments are expensed as rent is incurred
Describe capital leases and their basic accounting.
•The lessor transfers some of the rights and benefits of ownership to the lessee.
•The arrangement is treated as a borrowing and a purchase.
◦Borrowing: The lessee records a liability for the present value of the minimum lease payments and amortizes the liability as payments are made, similar to a mortgage loan.
◦Purchase: The lessee records the property as an asset and recognizes amortization expense, similar to depreciation on owned assets.
What are some reasons that most organizations prefer to record leases as operating leases rather than capital leases?
- Loan covenants often require businesses to not exceed a certain amount of debt.
- Operating leases are not considered part of an organization’s capital budgeting process.
- Capital leases impact certain financial ratios negatively, like Asset Turnover and Debt to Asset Ratio.
- Operating leases are simpler than capital leases from an accounting perspective.
List the four criteria to determine if a lease should be recorded as a capital lease.
Note: Only one of these criteria must be met to classify a lease as capital.
- There is an automatic transfer of ownership to the lessee at the end of the lease term.
- There is a bargain purchase option—an option to purchase the asset significantly below expected market value at the end of the lease term.
- The lease term exceeds 75% of the expected useful life of the asset.
- The present value of the minimum lease payments exceeds 90% of the fair market value of the asset.