Question 5 OR (b)
Operating lease versus finance lease
6 marks
- Time to write
- About 12 minutes
- Topic
- Leases and AS 19
- Notes
- Crux notes
Question
Question 5 OR (b) · 6 marksDistinguish between an operating lease and a finance lease.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Distinguish betweenSet the differences out in a table, basis by basis, not as two separate essays.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Six bases of distinction, one mark each 6 marks 10 min
- Check: every ask answered, key terms underlined 1 min
Try it first. About 12 minutes for 6 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
The deciding test. “Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than its form” (AS 19, para 8). A finance lease transfers substantially all the risks and rewards incident to ownership to the lessee; an operating lease is one that does not.
1The press is signed over for nearly its whole life—oiling, repairs and all are the lessee's now.
Finance leaseA lease that transfers substantially all the risks and rewards incident to ownership of an asset
2The laptops come like a rental: used for the season, then carried back out the door.
Operating leaseLike a rental agreement
| # | Basis | Finance lease | Operating lease |
|---|---|---|---|
| 1 | Risks and rewards of ownership | Substantially all transferred to the lessee | Retained by the lessor |
| 2 | Nature of the arrangement | A form of loan: the lessor acts as financier | Similar to a rental agreement |
| 3 | Lease term against economic life | Long-term: covers the major part of the asset's economic life | Short: shorter than the asset's economic life |
| 4 | Cancellation | Not cancellable by the lessee before the end of the agreement | Can be cancelled before the lease period expires |
| 5 | Repairs, maintenance, insurance, obsolescence | Borne by the lessee | Borne by the lessor |
| 6 | Accounting by the lessee | Asset and liability both recognised; lessee charges depreciation and a finance charge | Lease rentals charged as an expense; no asset or liability recognised |
Sources for the table. Rows 1–5 follow the DU text's own comparison of the two kinds of lease, definition, nature, maintenance, obsolescence and duration, and its features of each: a finance lease is not cancellable by the lessee, while an operating lease is subject to cancellation and is short in relation to the asset's life. Row 6 follows from the DU text's statement that under an operating lease the lease rental is shown as an expense in the profit and loss account.
A practical indicator. In a finance lease the present value of the minimum lease payments is substantially all of the asset's fair value: the DU text puts it at at least 90% of the cost of the leased asset. A lease whose payments are worth, say, 93.6% of the fair value is a finance lease even if the asset goes back to the lessor at the end.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1–6 | Six bases of distinction, one mark each | 6 |
| Total | 6 |
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