Capital Lease vs Operating Lease - YouTube

hello everyone hi welcome to the channel of Wallstreetmojo

friends today we are going to learn a tutorial on capital lease vs operating

lease and we'll be looking at some of the differences so let's get into an

nitty-gritty of the same first we'll understand the difference between the

capital lease and operating lease lease is a lot first right for you over here cap

and operating leases contractual agreement between the lessor that is the

owner of the assets and the lessee that is the real who rents the asset so its

lessor and and there is one called lessee right so there are two parties

this are classified into two one is called the operating another one is

called capital lease depending on how the risk of the ownership has the and the

benefits are been transferred what is lease at the very first one see lease is

an arrangement by which the lessor it conveys to the lessee in return for the

payment of series of payment the right to use and the assets for the agreed

period of time so in an agreement of the lease the lessor and the lessee enter

into an arrangement in which the lessor transfers the right to use an asset to

lessee against a payment of the lease rental for a period of time

so in some cases if mention in the agreement or according to the term in

the condition of the leased lessee has a right to acquired ownership of the

assets and the lease at the end of the lease period so before we proceed you

should know the difference between the lessor and the lessee now the lesser is

the capital leasing company banks or other independent and the lessee in case

are like transportations like trucks aircrafts real estate buildings

construction agriculture and so on and so forth so before we look into the

difference of capital vs operating lease let's understand each of them in

detail first the operating lease the operating

lease is stated as a lease arrangement which does not involve the transfer it

does not involve any transfer any transfer of these substantial risk

and rewards of the ownership of the assets leased to the lessee operating

lease generally have a period which is significantly which is less than the

fair value of the assets leased now leases that do not need any of the four

criteria are accounted for an operating lease the first test is that there

should be a transfer of the ownership like the test one for the capital lease

vs operating leases that transfer of ownership transfer of ownership is the

first difference second test to for the capital lease vs operating lease is

that the bargain purchase option that is the second point of difference if yes

then capital lease and if no then the operating lease in case of transfer of

ownership again if yes then capital is if no then the operating lease the third

test that you need to go for for capital vs operating lease is that the lease

term if greater than equal to 75% of the economic life yes then capital ease if

no then operating lease and finally the test for for capital lease vs operating

lease is the present value of the payments the present value of the

payments over here if it is greater than equal to 90% of the fair market value if

yes then capital lease if no then operating lease now let's look at the accounting

treatment of the operating lease now in the books of lessee the operating lease

does not result in recognition of assets or liabilities in the balance sheet of the

lease lessee lease payments other then the cost of the service like insurance

extra should be recognized as an expense on the straight-line basis in

the profit and loss account however if there is some other basis which is more

represented with a time pattern of the users benefit then lease payments should

be recognized using that basis now in the books of lesser in the

books of lesser and operating Lease should be accounted for in the following

manner like you know the transaction is not transaction of sale hence no selling

profit is to be recognized second the assets given under the operating lease

is to be shown in the balance sheet under the fixed assets cost including

like depreciation are recognized as in depreciation is recognized as an expense

that is the depreciation is to be charged in accordance with in normal

depreciation policy of the lessor by allocating over the lease term in

proportion of the recognization of the rent income by treating them as an

expense of the period by which they are incurred that is by taking them to the

profit and loss account of the yo now let's look at the accounting treatment

of the capital lease capital lease in the books of lessee if you talk about in

case of capital lease the recognition of the lease as an asset and the liability

at the inception of the lease the lease should be recorded at the fair value

okay of the leased asset at the inception of the lease and not exceeding

the present the value not exiting the present value of the minimum lease payment

from the lessees perspective so present value the minimum lease payment is to be

calculated using the IRR method over here now in the books of lessor the capital

lease should be accounted in the manner as in the balance sheet the leased

assets are recognized as debtors or the receivables at an amount equal to the

net investment in the lease the lease the lease payment is related to the accounted period

other than the cost of the service are reduced from both the principle in the

financial unearned income the finance income is allocated over the lease term

in the manner that return on the net investment outstanding for the various

period in the constant and unguaranteed residual values are reviewed regularly

let's see one example of a capital lease see in case of a let's say ABC limited is in

a rail company which has we know been leased out generator from DEF limited

to provide backup to the transporters system during the power outlet so the

lease period is close enough to 6 years the term in which ABC limited has

is is $4 lakh in terms of payment to DEF at the end of each year

and the rate of interest implicit to the lease is close to close enough to 10%

so the present value factor for the 6 years for the 10% is

4.355 let's see how the answer goes the present value of the

over here as we just understood the present value of the minimum lease

payment is equal to 4 lakh that is the payment into the present value

factor that is over here 4.355 which will give you 1724000

now how does the analyst perspective on the capital lease

accounting work I'll show you an effect on the balance sheet how things work out

if you see the balance sheet impact there is no impact on the balance sheet

of the lessee the operating lease at the inception that is your assets is equal

to liability + shareholder equity there'd be no entry over here no effect

over here the end result will be no effect there will be no changes

operating lease as a as a payment are made so the assets is equal to liability

plus shareholders equity over here the cash will reduce because of the periodic

payments that have been made and over here the shareholders the flows through

the income statement as a rent expense accordingly your shareholders equity

will also reduce so now let's consider the effect of the income statement see

the interest payment that is the discount rate the first the effect on

the income statement that is the interest expense so in case of his

interest expense the discount rate at times the lease liability at the

beginning of the period the second is the depreciation period calculation for

in in case of income statement effect if the lease transfer transfers the

ownership then depreciate the assets over the economic life of the asset if

the lease does not transfer the ownership then depreciate over the term

of the lease now the effect on the cash flow let's understand the effect on the

cash flow now in this case only the portion of the lease payment that is

considered as interest payment reduces the CFO and part of the lease

considered payment on the principle reduces the CFF