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# Capital and Operating Leases

Casey King Enterprises entered into two noncancelable leases for new machines to be used in its manufacturing operations. The first lease does not contain a bargain purchase option; the lease term is equal to 80% of the estimated economic life of the machine. The second lease contains a bargain purchase option; the lease term is equal to 50% of the estimated economic life of the machine.

1. How should a lessee account for a capital lease at its inception? Give a sample journal entry of the items to be posted. Include the formulas and calculations needed to determine the amount for each line in the sample journal entry.

( I started with this and now I am not sure that I am on the right track)
The lessee will increase their asset account of machinery and increase their
liability account creating a lease payable for the full value of the machine including any interest being charged.
Machinery -------->> Total Price + Interest
-------->>>Lease Payable ------->>> Total Price + Interest

2. How should a lessee record each minimum lease payment for a capital lease? Again, give a sample journal entry of the items to be posted. Include the formulas and calculations needed to determine the amount for each line in the sample journal entry.

(I think I am on the right track, but I don't know where to go from here)
The amount capitalized by the lessee is the present value of the minimum lease payments. If the fair value of the machine is less then the recorded value of the machine should be limited to that.

3.How should a lessee report a capital lease on its balance sheet and its income statement at the end of the year?

4.How should a lessee report an operating lease on its balance sheet and income statement each year?

#### Solution Preview

Hi there,

Here is what you need to know in terms of capital vs operating leases:

Firms often choose to lease long-term assets rather than buy them for a variety of reasons - the tax benefits are greater to the lessor than the lessees, leases offer more flexibility in terms of adjusting to changes in technology and capacity needs. Lease payments create the same kind of obligation that interest payments on debt create, and have to be viewed in a similar light. If a firm is allowed to lease a significant portion of its assets and keep it off its financial statements, a perusal of the statements will give a very misleading view of the company's financial strength. Consequently, accounting rules have been devised to force firms to reveal the extent of their lease obligations on their books.

There are two ways of accounting for leases. In an operating lease, the lessor (or owner) transfers only the right to use the property to the lessee. At the end of the lease period, the lessee returns the property to the lessor. Since the lessee does not assume the risk of ownership, the lease expense is treated as an operating expense in the income statement and the lease does not affect the balance sheet. In a capital lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits. Consequently, the lease, when signed, is recognized both as an asset and as a liability (for the lease payments) on the balance sheet. The firm gets to claim depreciation each year on the asset and also deducts the interest expense component of the lease payment each year. In general, capital leases recognize expenses sooner than equivalent operating leases.

Since firms prefer to keep leases off the books, and sometimes prefer to defer expenses, there is a strong incentive on the part of firms to report all leases as operating leases. Consequently the Financial Accounting Standards Board has ruled that a lease should be treated as an capital lease if it meets any one of the following four conditions -
(a) if the lease life exceeds 75% of the life of the asset
(b) if there is a transfer of ownership to the lessee at the end of the lease term
(c) if there is an option to purchase the asset at a "bargain price" at the end of the lease term.
(d) if the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset.
The lessor uses the same criteria for determining whether the lease is a capital or operating lease and accounts for it accordingly. If it is a capital lease, the lessor records the present value of future cash flows as revenue and recognizes expenses. The lease receivable is also shown as an asset on the balance sheet, and the interest revenue is recognized over the term of the lease, as paid.
From a tax standpoint, the lessor can claim the tax benefits of the leased asset only if it is an operating lease, though the revenue code uses slightly different criteria for determining whether the lease is an operating lease.

When a lease is classified as an operating lease, the lease expenses are treated as operating expense and the operating lease does not show up as part of the capital of the firm. When a lease is classified as a capital lease, the present value of the lease expenses is treated as debt, and interest is imputed on this amount and shown as part of the income statement. In practical ...

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