Question

Explain why companies would want to have leases classified as Operating leases. What would the indicators be for this determination?

More detailed and better to give an example to explain! Thank you!!

Answer 1

Solution:

Following are the benefits of classifiaction of leases as operating lease;

i)Under Operating leases,both assets and liablities(Lease payments) associated with the lease are not required to be reported on the balance sheet,despite the fact that entities were using the assets and contractually obligated to pay the lease,thus effectively underreporting its liablities.Further Capital leases required separate depreciation and interest expenses,whereas operating lease required a lumpsum lease payment or rental expenses.

ii)No risk of obsolescene,as there is no transfer of ownership.

iii)Accounting for an operating lease is simpler.

iv)Whole Lease payments are tax deductible under operating lease whereas only interest portion are tax deductible under capital leases.

Indicators for determining whether leases are operating lease are as follow;

A lease is classified as capital lease(Finance lease) if it transfer substantially all the risk and rewards incident to ownership.All other leases are classified as operating leases.Situations that would normally lead to a lease being classified as a finance lease include the following:

i)The lease transfer ownership of assets to the lessee by the end of the lease term.

ii)the lessee has the option to purchase the asset at aprice lowerthan the fair value at the date option become excersiable.

iii)the lease term is for the major part of economic life of the asset.