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Finance or Operating Lease?

Lesson
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A lease is an agreement between the lessor (the owner of an item) and a lessee (the one who wants the item).

There are two types of leases: operating leases and finance leases.

It's very important to be able to look at a lease and categorize it appropriately, because they are recorded differently.

Every lease is considered an operating lease by default, unless one or more of the following conditions are met:

  1. Transfer of ownership - The lessee gets title to the item (during or after the lease).
  2. Bargain option - The lessee is guaranteed the option to purchase the item at a very low price when the lease ends.
  3. Lease term - The lease lasts at least 75% of the item's lifetime.
  4. Present value - The present value of the lease payments is at least 90% of the value of the item.
  5. No alternative use - The item is so specialized that the lender won't be able to find any other use for it after the lease.
Question
Bill corp., the ever-maligned pen manufacturer, is trying to classify its lease as either an operating or finance lease. The firm's accountants are fairly sure they are dealing with an operating lease, but they were stumped by this one fact:

You've been briefed with the following facts:

  • The item will last for 156 months, but the lease term is only for 72 months.

Is the company dealing with an operating lease or a finance lease?
Answer
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👉 Answer:

  • It's an operating lease.

👨‍🎓 Here are the steps to figure it out:

  • If the length of the lease is < 75% of the item's economic lifetime, it can be an operating lease.
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