Tag Archives | operating lease

Operating Lease

An operating lease is a short-term off-balance-sheet lease agreement. This type of lease is not recorded on the lessee’s balance sheet. This type of lease typically spans a small portion of the asset’s useful life, and the lessor retains the risks and benefits of ownership. For example, in an operational lease, the lessor is responsible for service and maintenance of the asset throughout the duration of the lease. You can also call it a service lease.

Operating Lease Treatment

According to GAAP, property leased with this kind of lease is not recorded on the lessee’s balance sheet. Lease payments are recorded as rent expenses on the income statement.

Finance Lease versus Operating Lease

There are two main differences between capital (finance) leases and operating leases.

1. With a capital lease, the lessee must record both a lease asset and a lease liability on their balance sheet. With an operating lease, this is not required.

2. With a capital lease, the lessee assumes both the risks and benefits of owning the asset. With an operating lease, the lessor retains the risks and benefits of owning the asset throughout the duration of the lease.

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Operating Lease
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Operating Lease

See also:

Capital Lease Agreement
Commercial Lease

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Lessor versus Lessee

See Also:
Sale and Leaseback
Capital Lease Agreement
Lease Term
Make-or-Buy Business Decision
Cost Driver

Lessee Defined

In a lease agreement, the lessee is defined as the party that pays for the use of the asset or property. The lessor is the party that receives payments from the lessee in exchange for the usage of its asset or property.

Lessor Defined

In a lease agreement, the lessor is defined as the party that receives payments in exchange for the usage of its asset or property. The lessee is the party that pays the lessor for the use of the asset or property.

Lessor versus Lessee

What’s the difference between lessee vs lessor? When you sign a lease, are you the lessor or lessee? When engaging in a lease agreement, a legally binding contract, it is important to know the difference between these two terms.

For example, consider a rental apartment. The tenant is the lessee. And the landlord is the lessor. The lessee pays rent to the landlord whereas the lessor receives payment from the tenant. The same is true for any lease or rental agreement. The lessee pays the lessor for the right to use the asset or property. In addition, the lessor receives payment from the lessee in exchange for the usage of the asset or property.

Operating Lease vs Finance Lease

In accounting, a distinction is made between an operating lease versus a finance lease. The difference is in the way the lease is recorded by the lessee in the lessee’s financial statements. There is also a difference in which party assumes the benefits and responsibilities of ownership of the asset or property.

Operating Lease Definition

An operating lease is a short-term off-balance-sheet lease agreement. An operating lease is not recorded on the lessee’s balance sheet. This type of lease typically spans a small portion of the asset’s useful life, and the lessor retains the risks and benefits of ownership. For example, in an operating lease, the lessor is responsible for service and maintenance of the asset throughout the duration of the lease. An operating lease is also called a service lease.

Finance Lease Definition

A finance lease, also called a capital lease, is a type of long-term lease agreement. A capital lease is recorded on the lessee’s balance sheet. Additionally, this type of lease typically spans most of the useful life of the asset. In a capital lease agreement, the lessee, the party receiving the asset or property, assumes both the risks and benefits of ownership.

Lessor versus Lessee

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Lease Agreements

Lease Agreements

A lease agreement is a legal contract between two parties for the usage of an asset or property over a set period of time in exchange for rent payments. The owner of the asset or property allows another party to use the asset or property for payments. Often a lease agreement includes an option to buy the leased asset or simply transfers ownerships to the lessee at the conclusion of the lease.

Parties in a Lease Agreement

The party that owns the asset is the lessor, or the landlord. The party that pays for using the asset is the lessee, or the tenant. The lessee is the party that pays for the usage of the property. The lessor is the party that owns the property and collects rent payments from the lessee.

Advantages of Leasing

A lease agreement can benefit the lessee by giving them access to and usage of an asset they might not be able to afford. For example, if a company is starting up and does not have the capital to purchase expensive equipment or machinery, the company would be better off leasing the equipment or machinery for monthly payments.

A lease agreement can benefit a lessor by turning an unused asset into a source of income. If the lessor owns a valuable asset but is not making use of it, they would be better off leasing it to another party who can make use of it, and in return receive the rental payments.

Types of Lease Agreement

In accounting, there are several types of lease agreements. The conditions of the lease agreement determine how the transaction is recorded in the company’s financial statements. The types of lease include capital lease, operating lease, and sale and leaseback.

In a capital lease, also called a financial lease, the lessee acquires all the benefits and responsibilities of ownership of the property. They must record the lease on their balance sheet as an asset with a corresponding liability.

An operating lease is also called a service lease. The lessor retains all the benefits and responsibilities of ownership. However, the property is not recorded on the lessee’s balance sheet.

Whereas in a sale-and-leaseback agreement, the owner of the property sells it to another party. Then, they immediately lease it back from that party. The owner becomes the lessee and the buyer becomes the lessor. Companies do this to free up cash that may be tied up in an illiquid fixed asset.

Lease Agreements

See Also:
Lessor versus Lessee
Sale and Leaseback
Capital Lease Agreement
Agency Costs
Make-or-Buy Business Decision

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Capitalization

See Also:
Company Life Cycle
Market Positioning
Insider Trading
Dispersion
Adjusted Present Value (APV) Method of Valuation
Capitalization Rate

Capitalization in Finance

In finance, capitalization in finance is the sum of a company’s debt and equity. It represents the capital invested in the company, including bonds and stocks.

Capitalization can also mean market capitalization. Market capitalization is the value of a company’s outstanding shares of stock. It also represents the value of the firm according to investors’ perceptions. It is equal to the number of shares outstanding multiplied by the share price.

Market Capitalization = Shares Outstanding x Share Price


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Capitalization in Accounting

In accounting, capitalization refers to recording costs as assets on the balance sheet instead of as expenses on the income statement. A company may record the purchase price of an asset, as well as the asset’s acquisition costs, such as transportation and setup, as assets on the balance sheet.

Capitalization in accounting also refers to transferring an off-balance-sheet operating lease onto the balance sheet and recording it as a capital lease. To do this, calculate the present value of the future operating lease payments and record the amount on the balance sheet as an asset with a corresponding liability.

Capitalization of Cost

For example, a manufacturing company may record the cost of raw materials, direct labor, and overhead as assets – where labor and overhead would be capitalized costs. The assets (including the capitalized costs) are then transferred to the income statement as costs of goods sold as the underlying assets are sold to customers. Capitalizing costs increases the value of total assets and equity on the balance sheet, as well as net income on the income statement.

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Capitalization in Finance, Capitalization in Accounting

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Capitalization in Finance, Capitalization in Accounting

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Operating Leases Going Away?

The FASB (Financial Accounting Standards Board) and the IASB (International Accounting Standards Board) are recommending that the use of operating leases be scrapped. In addition, they are recommending that you treat all leases as capital leases. For over 40 years, FAS 13 has been the standard. But this step will change all that.

Operating Leases Going Away?

Under the proposed rules operating leases will be capitalized with both an asset and a liability account. Rent expense would go away and depreciation and interest expense would take it’s place.

Why is this important to a CFO? It’s the financial ratios! EBITDA no longer becomes useful in valuing a company. Your debt to equity ratio becomes inflated and the debt service coverage ratio becomes compressed. You will have to modify all your bank covenants to reflect the new presentation.

The question is: does this increased complexity add value to the process of evaluating the financial performance of a company? We will have to wait and see. Until July 2010 the accounting regulators are soliciting comments to their proposed changes. Implementation would not begin until 2011.

If you want more tips on how to improve cash flow, then click here to access our 25 Ways to Improve Cash Flow whitepaper.

operating leases
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operating leases

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