Question

Respond to the following in a minimum of 175 words:

Two common types of leases are operating and financing leases. In your own words, describe and share examples of each. What are the major differences in accounting for each of these two types of leases?

Answer 1

ANSWER:

Lesser shall classify the lease contract into one of the following contracts before making any recognition in the books of accounts viz.

1. Finance Lease
2. Operating Lease

1. FINANCE LEASE

As per the GAAP rules, Finance Lease is a contract whereby lesser transfers all the risks & rewards to lessee incidental to ownership. In simple terms, it is treated like Loan.

The following indications may be considered to classify a lease under finance lease:-

1. If the leased asset covers major part of the useful life of Leased Asset.
2. If the lessee is bound to acquire the leased asset at the end of leased period.
3. If there is an option to lessee to purchase the leased asset at the end of lease term.
4. If the present value of lease payment becomes equal to or higher than fair value of leased asset.
5. If the nature of asset is such that it is relevant for lessee only.

Example:-

A has given a machine on lease to B and the terms are such that B will pay lease rentals to A at a predetermined period and property in asset will pass on to B during or after lease period. B along with right to use the asset also gets all the risks and rewards incidental to ownership against series of lease payments. Then it shall be classified as finance lease.

2. OPERATING LEASE

If any lease cannot be classified as finance lease then it should be classified as operating Lease. It is an agreement to use the asset without ownership.

Example:-

A has given a machine on lease to B and the terms are such that B will pay lease rentals to A at a predetermined period and property in asset never pass on to B. B only gets right to use the asset and series of lease payments.