Many organizations lease property, plant, and equipment because of the following advantages or lease transactions:
1. 100% financing
2. Protection against obsolescence,
4. Less costly financing, and
5. Possible tax advantages.
A lease is an agreement conveying the right to use property, plant, and equipment (PP&E) usually for a stated period of time. Specifically excluded are lease agreements to explore or exploit resources such as oil, gas, minerals, and timber, and licensing agreements for items like motion picture films, plays, manuscripts, patents, and copyrights. A lease is a contract agreement between a lessor and a lessee that conveys to the lessee the right a specific property owned by the lessor, for a specified period of time. In return for this right the lessee agrees to make periodic cash payments (rents) to the lessor.
A good approach to understand the accounting treatment of non-operating type lease is to draw a time line and reflect all the cash flows associated with the lease, which are expected by the party for whom you are accounting. For the lessee, those will be the minimum lease payments. For the lessor, those will be the minimum lease payments plus any unguarenteed residual value to the lessor.
Leases are classified as operating leases and capital leases from the standpoint of the lessee. Four criteria must be evaluated in determining if a lease is a capital lease. If at the inception of the lease agreement the lease meets one or more of these criteria, then it should be accounted for as a capital lease:
1. The lease transfers ownership of the property to the lessee,
2. The lease contains a bargain purchase option,
3. The lease term is equal to 75% or more of the estimated economic life of the leased property,
4. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the leased property.
When recording a capital lease the following occurs:
1. An increase on the amount of reported debt short-term and long-term,
2. An increase in the amount of total assets, long-lived assets
3. A lower net income early in the life of the lease, thus, lower retained earnings.
The total charges to operations are the same over the length of time the asset is used by the lessee regardless or the lease being accounted for as a capital lease or as an operating lease.
From the standpoint of the lessor, leases are classified as follows:
· Operating leases,
· Direct financing leases,
· Sales-types leases.