Question

Indicate whether the company in each separate case 1 through 3 has entered into an operating lease or acapital lease.

1. The lessor retains title to the asset, and the lease term is three years on an asset that has a five-year useful life.

2. The title is transferred to the lessee, the lessee can purchase the asset for $1 at the end of the lease, and the lease term is five years. The leased asset has an expected useful life of six years.

3. The present value of the lease payments is 95% of the leased asset’s market value, and the lease term is 70% of the leased asset’s useful life.

Short answer

1. Operating lease
2. Capital Lease
3. Capital Lease

Step-by-step solution

Meaning of Operating Lease

Operating leases are short-term leases in which the lessor retains the risks and rewards of ownership.The lessee does not report the leased item as an asset or a liability (it is the lessor’s asset)

Step 2:Explanation

It is an operating lease as the lessor retains the risk & reward. In an operating lease, the lessee has no risks and rewards related to the leased asset.

Explanation

1. It is a capital lease as the title is transferred to the Lessee, and the Lessee has the right to purchase the leased asset at low / less than the market value / nominal value at the end of the life.
2. The substantial life of the asset is leased to Lessee.

Explanation

1. It is a capital lease as the Present value of lease payments is substantially equal to the leased asset.
2. The substantial life of the asset is leased to Lessee.