Question

Now why is it important from an accounting perspective to classify a lease into operating or capital lease? What is the criteria to classify the lease into operating and capital lease ? Do you think the lessee tends to prefer an operating lease or a capital lease? Why?

Answer 1

Lease is a method used for off- balance sheet financing. Lease is the right to use an asset without having to show the asset and corresponding liability in the balance sheet.

It is important to classify the lease into its two types, namely, operating and capital due to the implications it have on the financial statements of the firm.

Capital lease is the right to use the asset. When the lease meets one of the four conditions for being a capital lease, then the transaction is recorded by recognizing both the asset and a lease liability. The lease payments are split between liability reduction and interest expense. Also, leased asset is depreciated.

Operating lease is an executory contract.Neither asset nor liability is recognized. The lease obligation is reported only in notes to the financial statement. The payments are accrued and paid each period and an expense account is debited while either cash or accrued liability is recognized.

The lessee tends to prefer an operating lease for off-balance sheet financing when they want to keep their debt low and hence the leverage ratios low. Also, the main reason being the financing for an investment decision.

It will be better to lease an asset rather than purchasing it.

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