Leases Operating lease vs. financing lease (capital lease)

The two most common types of leases are operating leases and financing leases (also called capital leases). In order to differentiate the two, one must consider whether the risks and rewards associated with ownership of the asset have been fully transferred to the lessee from the lessor.

Let's walk through a lease accounting example. On January 1, 2017, XYZ Company signed an 8-year lease agreement for equipment. Annual payments are $28,500 at the beginning of each year. At the end of the lease, the equipment will revert to the lessor. The equipment has a useful life of 8 years and has no residual value. At the time of the lease agreement, the equipment has a fair value of $166,000. An interest rate of 10.5% and straight-line depreciation are used.

There is no bargain purchase option because the equipment will revert back to the lessor.

The life of the lease is 8 years and the economic life of the asset is 8 years. This is 100%.

Using a financial calculator, calculate for the PV of the minimum lease payments:

N = 8

I/YR = 10.5

FV = 0

PMT = 28,500

PV = 164,995

Therefore, 164,995/166,000 = 99%