In this video, I discuss the difference between operating lease and finance lease as covered on the CPA exam.
Start your free trial: farhatlectures.com/
When a lease is classified as an operating lease, it impacts the financial statements in specific ways. On the balance sheet, two items are recognized: a Right-of-Use (ROU) asset and a lease liability. These items represent the lessee's right to use the leased asset and the obligation to make lease payments, respectively.
To calculate the initial values of the ROU asset and lease liability, the present value of the future lease payments is determined. This calculation uses a discount rate that reflects the interest rate implicit in the lease or, if that rate is not readily determinable, the lessee's incremental borrowing rate.
Over the life of the lease, both the ROU asset and the lease liability are gradually reduced. The lease liability is decreased using the effective interest method, which means interest expense is calculated on the outstanding liability balance, and lease payments are applied against the interest expense and the principal reduction of the liability. The ROU asset is amortized in a manner that reflects the consumption of the economic benefits of the leased asset.
On the income statement, the total lease expense is recognized evenly over the lease term, following the straight-line method. This approach spreads the total cost of leasing (including interest) evenly, even though the actual interest expense (part of the lease liability reduction) may vary over the term due to the effective interest method.
Thus, unlike financing leases where interest expense and amortization are reported separately, in an operating lease, the lessee reports a single lease expense that combines these elements. This approach simplifies the income statement presentation but does not separately highlight the interest cost as part of the lease expense.
#cpaexaminindia #cpaexam #accountingmajor