Operating Capital Lease - Essay Example

I think that keeping operating leases off the book is a practice that should not be allowed. Most leases enable a company to use some property as if it was the firm’s. I think that during the duration of an operating lease, the property of the lease should be considered an asset of the company. At the end of the operating lease ownership of the asset would be transferred back to the lessor. The four criteria for capital leases should be abolished by the FASB and all leases behave as capital leases.

3.

The annual payment of $10,000 for 20 years means that the company will receive $200,000 during the duration of the lease. The cash in the balance sheet will be affected as each year it will grow by $10,000. At the end of the lease, the salvage value is $2,750. If the firm decided to buy the asset at the end of the lease this would be the price. If the firm buys the asset two accounts in the balance sheet will be affected. The equipment account will increase, while the cash account will decrease by $2,750. The fair market value of the asset at the inception of the lease is $92,625 and the estimated economic life of the lease is thirty years. Based on these two facts the company does not meet two of the criteria needed to classify the lease as a capital lease. This is an operating lease.

4.

The first lease is disqualified from being a capital lease because it does not contain a bargain purchase option. The second lease also does not qualify to be a capital lease because the lease term is not equal to at least 75% of the economic life of the asset.

Both leases are operating leases.

5.

Different criteria help accountants determine whether to classify a lease as an operating or capital lease. FASB Statement No. 13 establishes the four criteria that must be met in order to classify a lease as a capital lease. If a lease is classified as a capital lease the property that is leased by the firm becomes an asset that should be recorded in the balance sheet of a company. The lease contract must comply with four criteria. If any of the four criteria are not met the lease fails to qualify as a capital lease and instead becomes an operating lease. The four criteria established by FASB Statement No. 13 are:

1. a) The lease transfers ownership of the property to the lessee
2. b) The lease contains a bargain purchase option
3. The lease term is equal to 75% or more of the economic life of the leased property
4. The present value of the lease payments equals or exceeds 90% of the fair market value of the leased property

7.

The differentiation between capital and operating leases has a great impact on the financial statements of corporations. Operating leases do not transfer ownership of the property to the firm, thus the item leased is not considered an asset of the firm. Capital leases on the other hand are contractual obligations that create both a liability and an asset in the balance sheet of the firm. The use of capital leases discloses better in the financial statements the actual assets being used by the company.

6.

I mentioned earlier in the other question associated with this problem set that the lease did not qualify to be capitalized because more than one of the criteria under FASB Statement No. 13 was not met. The lease affects the cash flow because each payment reduces the total cash of the firm. Each payment affects the income statement as the payment represents an expense. Calculating depreciation is not relevant because the property should not be included in the balance sheet of the company.

8.

The first lease has two terms. One of the terms is that the lease equals 80% of the economic life of the asset. Based on this term the lease would qualify as a capital lease. The second term is that the lease does not have a bargain purchase option. Based on this term the lease does not qualify as a capital lease based on SFAS No. 13. The second lease has two terms as well. The first term is that it has a purchase bargain option. So far the lease would qualify as a capital lease. The second term is that the lease equals 50% of the economic life of the asset. Based on the second term the lease does not qualify as a capital lease based on the four criteria mentioned on SFAS No. 13.

9.

Weekly Summary

This week I learned a lot about leases. Leases are a great alternative for business because they can give companies alternative access to the financing they might otherwise not qualify for based on banking industry standards. I did not know before taking this course that leased can be classified as either operating or capital. A capital lease gives the lessee ownership of the asset at the end of the life of the contract. During the week 3 individual paper I also learned that from the lessor’s perspective, capital leases can be classified as either direct financing, sales type, or leveraged leases.