-Imagine you are the senior accountant at an organization and management is cons
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Question
-Imagine you are the senior accountant at an organization and management is considering leasing some equipment; however, management is unsure of the impact that a capital lease would have on the company. Briefly describe the manner in which a capital lease would be accounted for by the company both at inception of the lease and during the first year of the lease, assuming that lease transfers ownership of the property to the lessee at the end of the lease.
-From the previous bulleted discussion, assume that management now has a clear understanding of capital leases, but has been informed by colleagues that an operating lease may be more beneficial than an operating lease, since the useful life for the equipment is only eight (8) years. Compare and contrast a capital lease and an operating lease, and recommend to management what type of lease would be beneficial since the equipment will become obsolete in eight (8) years. Provide a rationale for your recommendation.
Explanation / Answer
Accounting for Capital lease at the inception of lease:
In an operating lease, the lessor transfers only the right to use the asset to the lessee. At the end of the lease period, the lessee returns the property to the lessor.The lease expense is treated as an operating expense in the income statement and the lease does not affect the balance sheet as the lessee is not the owner of the asset.
Whereas, in a capital lease, the lessee assumes risks of ownership and enjoys benefits. when the lease is signed, it is recognized both as an asset and as a liability on the balance sheet. The lessee gets to claim depreciation each year on the asset and also deducts the interest expense component of the lease payment each year. In general, capital leases recognize expenses sooner than equivalent operating leases.
As most of the firm do not like to show lease in its books, and prefer to defer expenses, there is a strong incentive on the part of firms to report all leases as operating leases.
We can identify a lease as capital lease if it meets the following criteria:
(a) if the lease life exceeds 75% of the life of the asset
(b) if there is a transfer of ownership to the lessee at the end of the lease term
(c) if there is an option to purchase the asset at a "bargain price" at the end of the lease term.
(d) if the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset.
We should chhose the capital lease as the lease life exceeds 75% of the life of the asset and the company can claim depreciation and tax benefits.
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