Lease Classifications Definition:

 The term “lease” can be defined as the contract between the lessor and the lessee, to hire any asset for a specified period, and a fixed amount.  The Lessor rents out the particular asset. The Lessee loans the said asset from the Lessor.

Types of Leases:

The lease division comprises of two main categories:

  • Operating lease.
  • Finance lease.

Finance leases: This type of lease is also known as the capital lease, where the lessee will obtain the legal ownership of the leased property, before the end of the contract. In other words, a financial lease allows the lesser to transfer all the benefits and liability, attached to that particular leased asset, before the termination of the lease agreement, to the lessee. However, during the period of the lease, the lessee is responsible for the repairs and maintenance, as this category of a contract is nothing but a camouflaged loan. Some of the critical terms are

  • Besides, the finance lease allows the asset to be used only by the lessee who signed the lease agreement.
  • Also, the period of the contract usually covers more than 75% of the asset’s useful lifetime.
  • The lessee generally pays at least 90% of the asset’s current value.
  • This lease considered non-cancellable, although it is feasible for early termination.
  • Ownership may transfer to the lessee at the end of the contract at lower than the fair value
  • Risk related to assets transferred to the lessee, who is responsible for paying maintenance, insurance, and taxes.

Operating leases: The renter can use the assets and enjoys practically all the benefits and disadvantages of owning the property in capital rentals. If all conditions met, a change between risk and benefit happens. Unless the following terms met, leases deemed to be a capital contract:

  • The rental period is less than 75% of the asset’s useful lifetime
  • The Present Net Value (NPV) of rental payments is less than 90% of the Asset’s fair value
  • The contract agreement or clause stipulates no title transfer – or – the lease term doesn’t allow the lessor to purchase a property at a reduced price at the end of the lease.
  • Lessor retains the ownership at the end of the contract
  • The risk remains with Lessor, who is responsible for paying insurance and taxes. Either lessee or lessor may pay the maintenance cost

How to Record a Lease in The Books?

 Finance Lease: Example

Let’s suppose a Sky company (Lessee) that leases a car from Cloud company (Lessor). The contract is for five years, and after each year, Lessee will compensate Lessor $100,000 per annum, and the present value of the assets is $ 435,000.   In the situation where PV’s fixed lease payment is $432,947 at an implied in the loan is 8%. Here the lease rentals are more than 90% of the value of assets and hence classified as Finance Lease

Accounting for Lessor

The Lessor shall report the beginning of the lease by establishing a lease that is comparable to the required lease payment, at the rate of interest indicated in the contract, on his net lease contributions:

Buying of assets
Asset (Dr)$435,000
Cash (Cr)$435,000
Enter in lease contract
Lease receivable$432,947
Asset$432,947

The lessor shall report at the point of actual lease collection, lease payable decrease, and financial income recorded:

Cash$100,000
Lease receivable$78,353
Finance income$21,647
Accounting for Lessee

The effect of a mortgage is the identification of both an income and the debt in the leaser’s accounts, which is equivalent to the present value of the lease payments at the outset of the contract.

Leased asset$432,947
Lease liability$432,947
Depreciation Accounting
Depreciation (Dr)$86,589
Accumulated Depreciation (Cr)$86,589
Interest Expenses Recording
Interest Expenses (Dr)$21,647
Interest Expenses Payable (Cr)$21,647
Lease Payment Recording
Interest Expenses Payable (Dr)$21,647
Lease liability$78,353
Cash (Cr)$100,000

 

Operating Lease: Example

Accounting for Lessor

Let say the asset fair value is $ 1 mn with total life is 15 years and lease rental is $ 100,000, then following accounting entries are passed in the book

Buying of assets
Asset (Dr)$1,000,000
Cash (Cr)$1,000,000

The lessor shall accept the receipt of leasing during the first year as follows:

Cash$100,000
Lease rental income$100,000
Depreciation Accounting
Depreciation (Dr)$66,666
Accumulated Depreciation (Cr)$66,666
Accounting for Lessee

The accompanying journal entry is necessary at the time of lease payment:

Lease expense$100,000
Cash$100,000

 

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