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Operating Leases and Classifications

Please explain, in basic terms, operating leases and its effect on classifications, carrying value and earnings based on FASB Codification. Give an example to explain.

FASB, ASC-840-10-10-1:
The objective of the lease classification criteria in this Subtopic derives from the concept that a lease that transfers substantially all of the benefits and risks incident to the ownership of property should be accounted for as the acquisition of an asset and the occurrence of an obligation by the lessee and as a sale or financing by the lessor. All other leases should be accounted for as operating leases.

FASB, ASC-840-20-25-1:
Rent shall be charged to expense by lessees (reported as income by lessors) over the lease term as it becomes payable (receivable). If rental payments are not made on a straight-line basis, rental expense nevertheless shall be recognized on a straight-line basis unless another systematic and rational basis is more representative of the time pattern in which use benefit is derived from the leased property, in which case that basis shall be used.

Based on Business Encyclopedia, ISBN 978-1-929500-10-9. Revised 2013-02-02:
An operating lease contract is similar to a rental contract: The lessee pays fees for the life of the lease and simply uses the goods (e.g., a computer system, or a vehicle). The lessee reports these costs as operating expenses (thereby lowering reported income and tax obligations), but takes no depreciation expense. The lessor (owner), however, can claim depreciation expenses and take tax benefits. When the lease term is over, the lessee surrenders the property (or renews the lease, or perhaps has an option then to purchase outright). Operating leases differ from rental contracts, primarily in that leases are more binding (have bigger penalties for early canceling), and usually cover longer terms. An operating lease generally covers a time period significantly less than the expected life of the leased goods.

Solution Preview

An operating lease has a term relatively short when compared with the useful life of the asset/piece of equipment. The operating lease agreement allows for the use of the asset but does not pass the ownership of the equipment/asset. For example, five press machines are leased for a period of three years. The life of each machine is seven years. The FASB, ASC-840-10-10-1 says that if a lease transfers most of the benefits and risks related to the ownership of the equipment/asset, it should be recorded as a purchase and the obligation to pay is to be treated as a loan. Otherwise the lease is ...

Solution Summary

This solution provides an explanation of operating leases. The references related to the solution are also included.