12. Leases

Question 1

Describe operating leases and their basic accounting.

Answer 1

• 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

Question 2

Describe capital leases and their basic accounting.

Answer 2

•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.

Question 3

What are some reasons that most organizations prefer to record leases as operating leases rather than capital leases?

Answer 3

• 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.

Question 4

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.

Answer 4

• 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.