Finance Leases vs. Operating Leases

Leases are used by many companies to obtain assets for use, such as equipment. A __finance lease__ is of such duration and total cost or ultimately transfers ownership to the lessee that it is economically equivalent to a purchase, or nearly so. An __operating lease__ is similar to a rental; this allows the lessee to use the asset for a specified period of time. Think about what these differences mean to both parties. Which of the following conditions might make a lease a finance lease?

That's right.

This is incorrect.

To some degree, financial reporting for the two types of leases depends upon the type of lease. Under both IFRS and US GAAP, any one of these five criteria will make the lease a capital lease: 1. Ownership of the asset is transferred to the lessee. 2. The lessee has an option to purchase the asset and probably will. 3. The lease term is for a major part of the asset’s useful life. 4. The PV of the lease payments equals or exceeds fair value. 5. The asset has no alternative use to the lessor. What would you decide if only two of these criteria were met?

No.

Very good!

Suppose Gaines Inc. leases equipment from Equipment Pro Inc. The lease is considered a finance lease based on the present value of the lease payments. What change would cause this to be considered an operating lease instead?

Incorrect. If the PV of lease payment criterion qualified the lease as being a finance lease, the length of the lease will not disqualify it.

Incorrect. If the PV of lease payment criterion qualified the lease as being a finance lease, any ownership plans will not disqualify it.

Exactly! If the lease was determined to be a finance lease due to the PV of lease payments, they must have been equal to or greater than the estimated value of the equipment. Reversing this can be done with a much higher fair value estimate of the equipment. But remember: under both IFRS and US GAAP, it just takes one of the five!

To sum it up: [[summary]]

Only one is needed; two is more than enough to call it a finance lease.

If the equipment is specialized, the lessor most likely would be unable to find another lessee. It makes more sense to construct the lease as a capital lease. But if the lease does not cover the useful life of the asset, it would be similar to a rental and therefore would be an operating lease.

The asset/equipment is specialized and can only be used by the lessee unless major modifications are done to the asset

The term of the lease is only for a short period of time, which does not constitute most or all of the economic life of the leased asset

It must be an operating lease

It must be a finance lease

The fair market value of the equipment is much larger than originally estimated

Gaines isn't planning on owning or purchasing the equipment

The lease term is shorter than the equipment's useful life

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