 In this discussion, we will discuss the discussion question of compare and operating lease and capital lease Support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website Broken out by category further broken out by course each course then organized in a logical Reasonable fashion making it much more easy to find what you need than can be done on a YouTube page We also include added resources such as excel practice problems PDF files and more like QuickBooks backup files when applicable So once again click the link below for a free month membership to our website and all the content on it So if we see a discussion question like this or an essay question like this We can first try to decide what a lease is if we don't know where to get started Or we don't even really know what an operating lease or capital lease is we can at least get going and say what a lease is and How a lease is typically going to be recorded? So if we get into what is a lease if we were to lease something like equipment We're basically renting the equipment and what that would mean is the leasee the person leasing or the company Leasing would not have ownership over the equipment But would be renting borrowing the equipment and the journal entry It's always useful to think of the journal entries related to many of these types of questions The journal entry related to that would just simply be that when we make the payments on the least equipment We would credit cash for the for the equipment that we leased and we would be debiting something like a rent expense or lease expense And so in that situation the lease or the person that's being leased from they still retains the ownership of The property the equipment the leasing is just using the equipment and paying for it on a Rental type basis and that could be similar to something like paying you know rent on on office buildings or something like that We're just using the office building. We don't own the office building and we would just be expensing The payments as we make them Now that would be a normal lease and we would call that a normal operating lease So that's an operating lease So even if we didn't know the terms between operating and capital we could start to describe You know what a lease is and we would basically be picking up what an operating lease is and Then to compare these two what is an operating lease versus a capital lease this being the different type of lease This would be something where there's a substance over form argument Meaning in substance what's really happening is there's a sale that took place the argument for a capital lease is that This is really a sale. You may have written it up as a lease, but it looks like a sale Why would it be a sale? Because the lease term is such that it looks like the leasee has ownership of of the property meaning the leasee in Some way has complete control over it seems like they totally paid for it possibly and they have control over the over the Equipment and therefore even though it's written up as a lease we think in form. It's actually a purchase and So the argument there is that we need to record it as a purchase No matter what the substance of the agreement is so even though it's written up as a lease We have to write it down as a purchase So in that case what you can really think of it as that the capital lease is like a purchase We have to treat it like a purchase Whereas an operating lease is just like normal where you think would be a normal lease Just like if you lease an apartment or something or lease the office building where we would just write up the expense So for a normal operating lease, it's really easy. We just we just every time we make a payment We credit cash and we debit the lease expense or rent expense for a capital lease We've got to treat it as a purchase and so you can go through the series of journal entries as a result in this to Give some more explanation for a question like this So what would happen when the lease happens? Well, if when we when we take out the lease when we signed the lease agreement Then we would have to record it as a capital asset Meaning we'd have to debit like a capital asset like least equipment as an asset account on the books And then we'd have to credit something like an obligation under the lease like a loan So we would debit Equipment some type of equipment like an asset operating or a capital lease asset and then something like a loan an Obligation under the capital lease And you might ask well, where would we get that amount the loan amount because it's not It's it might not be on the agreement We would have to basically figure out what what the amount would be that we purchased it for based on the terms of the agreement So we don't need to get too much detail on that But we'd have to basically put it on the books then and what that means is that we'd have a liability on the books Which is probably if someone was trying to put something on as a lease an operating lease rather than a purchase It may be because the lease he didn't want the loan on the books That might be something that they didn't want there and that maybe that's why but we have to have the loan on the books If it's in substance of purchase Then what's the other consequence if if we have the equipment on the books? That means that when we make the payments the lease payments according to the to the agreement Then what we're really doing is paying off the loan that now we put on the books the obligation So that means that we're gonna credit cash every time we make the payment But instead of debiting just lease expense or rent expense We're gonna reduce the loan amount that we put on the and we're gonna record some type of interest Related to it So we're gonna be making payments in a similar way we would if we were just paying off some type of note like an installment note and then the other thing that we're gonna have to do if we are owning the equipment is We're gonna have to record depreciation every time because we we basically have ownership of it under a capitalist or the person lease The lease E the person is basically the purchaser So they have ownership of the lease now of the equipment and they then need to depreciate it Which means they're gonna debit depreciation expense and credit accumulated depreciation For the for the depreciation expense of the equipment that has been capitalized and put on the books and note When it says capitalize what that means is that when you hear that term It basically just means that we're going we're gonna put something on the books as an asset We're gonna capitalize it We're gonna put it on the books as an asset in this case a property planned equipment And then we're gonna expense it over time as it's being consumed as it's being depreciated Now you can also get into some other things of why when would you have an operating lease versus a capitalist? I mean what would be the causes of that and Note that it's a substance over form argument that we're saying well in substance It looks like you purchased it well, when would that happen when would it look like you purchased it? Well, one would be if if the property just at the end of the lease just goes to the leasee Automatically so if you set up the agreement where it's like we're gonna have to pay this amount each Time period and then at the end of the at that time period the the property is gonna just shift automatically from the lease or to the leasee well, then that looks a lot like a purchase because the leasee has control of it forever and They're obligated to pay up to this point in time and then it's gonna revert back to them So you would think that that would be More like a purchase now you can imagine okay Well, what if someone wanted to set up an operating lease and they wanted to get around that and But they still want to set up a substance over form well They could say how about I just sell it to the individual at a bargain price maybe at the end of the lease We don't just give it away, but we sell it for like a dollar or you know A few dollars something very small compared to the value of the equipment Well, that clearly looks like it looks like there's a bargain purchase option at the end of the lease that was set up Possibly just to get around this requirement and therefore it still would if there's if it's gonna be in complete control of the leasee And then there's a bargain purchase option that almost is guaranteed to be taken by the leasee Then it still looks like it in substance is a purchase and not a lease So you would think you'd have to put it on the books as a capital least versus an operating lease It could be the case where if the leasee term is set up so that they have to hold the asset and make payments For over for most of the life of the equipment So like so if they if they're using the equipment for pretty much most of the useful life of the equipment Then you would think again It would seem like a purchase there if the agreement is such that we know this equipment will only last so long and the Leasee has it for that entire time period that looks in substance like a purchase and Finally, if there's a situation where we present value the future cash flows and They look like they're pretty much equal to the purchase price or somewhere near the purchase price of the equipment Again, it looks a lot like a purchase agreement because you're basically playing the present value of purchase price So those are some ways that we'd have to determine if something is in substance a capital lease Versus an operating lease and if we determine that it's in substance more of a purchase Then we would we would generally have to have a capital lease Recorded on the books as a fixed asset rather than just record the lease payments as expenses