FRA - Classification of leases

There are two basic categories of lease classification: the operating lease and the capital, or finance, lease.

What is an Operating Lease?

In an operating lease, the lessee receives the right to use the asset but does not record the asset or the lease payment liability on its balance sheet. Thus, the operating lease is considered to be “off balance sheet financing”. Instead, the lessee will record lease payments as rental expense in its income statement, either under cost of goods sold.

What is a Capital or Finance Lease?

In a capital lease, the lessee receives the right to use the asset and substantially receives all the benefits and risks of owning that asset. This transfer of risk and benefits occurs when certain criteria are met. A lease is deemed a capital lease if the following criteria are met:
  • The lease duration is 75% or more of the asset’s useful life
  • The net present value (NPV) of lease payments is 90% or more of the asset’s fair value
  • There is a direct term or clause in the lease stating transfer of title – or –
  • There is a term in the lease that enables the lessee, at the end of the lease, to purchase the asset at a discounted price (also known as a bargain purchase option, or BPO).
As opposed to the operating lease, a lessee with a capital lease records the asset and the corresponding lease liability on its balance sheet. The asset will be classified as plant, property, and equipment. The lease liability is classified as a form of debt.
The capital lessee will also depreciate the asset over time. If the lessee and lessor have agreed on a guaranteed residual value, then the lessee will depreciate the asset over time to this residual value.
Any non-cash financing for this lease is disclosed in the footnotes of the company’s financial statements.

Significance of the Lease Classifications

Because of the nature of each lease classification, there can be an impact on profit and debt capacity. Since operating leases are “off balance sheet”, the company’s capital structure does not change due to an operating lease. In contrast, a capital lease may make a company more debt-heavy, thereby impacting its debt capacity.

What is a Capital or Finance Lease?

In a capital lease, the lessee receives the right to use the asset and substantially receives all the benefits and risks of owning that asset. This transfer of risk and benefits occurs when certain criteria are met. A lease is deemed a capital lease if the following criteria are met:
  • The lease duration is 75% or more of the asset’s useful life
  • The net present value (NPV) of lease payments is 90% or more of the asset’s fair value
  • There is a direct term or clause in the lease stating transfer of title – or –
  • There is a term in the lease that enables the lessee, at the end of the lease, to purchase the asset at a discounted price (also known as a bargain purchase option, or BPO).
As opposed to the operating lease, a lessee with a capital lease records the asset and the corresponding lease liability on its balance sheet. The asset will be classified as plant, property, and equipment. The lease liability is classified as a form of debt.
The capital lessee will also depreciate the asset over time. If the lessee and lessor have agreed on a guaranteed residual value, then the lessee will depreciate the asset over time to this residual value.
Any non-cash financing for this lease is disclosed in the footnotes of the company’s financial statements.

Significance of the Lease Classifications

Because of the nature of each lease classification, there can be an impact on profit and debt capacity. Since operating leases are “off balance sheet”, the company’s capital structure does not change due to an operating lease. In contrast, a capital lease may make a company more debt-heavy, thereby impacting its debt capacity.

Comments

Post a Comment

Popular posts from this blog

Work certified and uncertified

Meaning of Work Certified  When contractor takes the contract to complete any construction work, it may complete in 4 or 5 years. but contractor has to pay different expenses for material, labor and others. So, it is very necessary to pay him some money of contract. This money is given on the basis of work done. So, any part of construction which is completed by contractor will be work certified if it is certified by an authority. Authority may be independent engineer or architect who can estimated the work. He will issue the certificate of work done after certifying the work of construction. On this work certified, contractor has right to get money of contract. Meaning of Work Uncertified Work uncertified means work done but not certified by authority. So, contractee will cut some money on the basis of work uncertified and will keep in his pocket. This will be retention money. Accounting Treatment of Work Certified and Work Uncertified  (I) Work  certified...
Read more

factors influencing choice of advertising agency

The Advertiser looks for an advertising agency whose services and expertise meets his requirements. Following factors should be considered while selecting an advertising agency:- Services offered by Ad-agency  - There are different agencies provides different services, some provides all the services, some provide selected services, some provides only media services. It depends on the requirement of advertiser whether he need a fulls service agency, creative boutique, media buying service agency, or a  sweet shop . Experience of Agency  - An experienced agency performs better then a new agency  because it is familiar with different components of marketing environment like- competitors' policies, taste of consumer, income of consumer, consumer responses, fashions and trends, reputation of different media etc. Location  - A major factor to be considered while selecting ad-agency is location of office of agency. A considerable amou...
Read more

Environment of International Marketing

Image
Apple is so successful because of their effective marketing efforts. They are good in identifying relevant environmental factors and trends which helps in taking advantage of opportunities and minimising threats.  New technological developments, global economic conditions, worldwide population changes, increased competition, legislative requirements, and political events are some of the factors affecting current and future marketing activities of the organisations around the world. Combination of such factors makes the International Marketing Environment. The long term performance of any organisation depends on its ability to identify and respond effectively to the key changes in its marketing environment.  Meaning of International Marketing Environment  International Marketing Environment is the combination of various factors external to an organisation that can affect the international marketing decisions of the organisation in international market. These fac...
Read more