Question

One of this week’s topics covered the accounting for leases on the consolidated financial statements. In 200 words or more, discuss the issues that relate to the accounting for operating and capital leases.

In your posting, please articulate issues that the accountant faces in recording such transactions and how they should be recorded on the financial statements of the company.

note: please no photos with text.

Answer 1

A lease can be a great way for your company to acquire equipment. The two main types of leases are operating and capital leases. Both types have different effects on a company's finances and are accounted for in different ways. Understanding the different types of leases will help you record them correctly on the financial statements.

Operating Leases

One of the advantages of leasing is being able to replace equipment as it becomes obsolete. With a lease, you just lease something newer. If you own equipment, you would have to dispose of the old equipment and buy a newer model. A lease also makes it easier to increase capacity temporarily; you just sign a short-term lease for the equipment instead of buying it. An operating lease is usually a short-term lease. With an operating lease, the equipment being leased is returned at the end of the lease. This is a viable option for the equipment you only need temporarily.

Capital Lease

Unlike an operating lease, a capital lease is a long-term lease. With a capital lease, you assume some of the risks of ownership and get some of the benefits. With a capital lease, you usually end up owning the equipment at the end of the lease or get an option to purchase the equipment. If the lease term exceeds 75 percent of the estimated life of the equipment, it is classified as a capital lease. The advantage of a capital lease is that at the end of the lease you have an asset -- something you own -- listed on your books. The downside is that the asset may be obsolete at that point.

Accounting for Leases

Accounting for an operating lease is different than accounting for a capital lease. With an operating lease, you record the lease payments as operating expenses. You would not list the equipment on the balance sheet, because you do not own it. With a capital lease, you record the remaining lease payments as a liability -- something you owe -- and the equipment as an asset. In other words, the lease is treated as if you purchased the equipment on credit. With a capital lease, you deduct the interest portion of the financing as interest expense and depreciation of the equipment as depreciation expense. Because expenses reduce net income, a capital lease can result in lower taxes than an operating lease.

Other Issues

Whether you have an operating lease or a capital lease, there are some issues to consider. First, find out if the equipment being leased must be insured. If you don't insure the equipment, the leasing company may charge you for the insurance on it. Another thing to consider is whether the company will charge you a penalty if you end the lease early. Finally, check the lease agreement for a maintenance schedule that may be required as part of the lease.

Financial Statement Balance Sheet Finance Lease Recognize ROU asset and lease liability at the commencement date of the lease. The lease liability, initially and subsequently, is measured at the present value of the unpaid lease payments. The ROU asset initially is measured at the amount of the lease liability initially recognized, plus initial direct costs and prepaid lease payments, less lease incentives received. The ROU asset is subsequently amortized generally on a straight-line basis. Operating Lease Recognize ROU asset and lease liability at the commencement date of the lease The initial and subsequent measurement of the lease liability, and the initial measurement of the ROU asset, are the same as for finance leases. The ROU asset is subsequently amortized in such a way so that the lease cost is recognized on a straight-line basis over the lease term in the income statement (which results in an increase in the periodic amortization of the ROU asset over the lease term). Income Statement Recognize interest on the lease liability separately from amortization of the ROU asset. Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term, generally on a straight-line basis. Cash Flows Classify all cash payments for leases within operating activities. Classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities.