Accounting: Capital vs. Operating Lease
Leasing equipment for your business is a financing option that allows you, the lessee, to have full use of the asset while paying for its use over time. It is important, however, that the financial treatment of the transaction is also taken into consideration at the time the contract is negotiated.
The Financial Accounting Standards Board (FASB) states that a lease should be treated as a capital lease if it meets any one of the following four conditions –
- if the lease life exceeds 75% of the life of the asset
- if there is a transfer of ownership to the lessee at the end of the lease term
- if there is an option to purchase the asset at a “bargain price” at the end of the lease
- if the Net Present Value (NPV) of the lease payments exceeds 90% of the fair market value of the asset
Lessee records the equipment both as an Asset and a Liability (NPV of lease payments)
Lessee depreciates the asset and records Interest Expense over the term of the lease
- Recognize expenses sooner than equivalent operating leases
- Increases both Assets and Liabilities on the Balance Sheet which alters some ratios used to measure strength of the company
- The risks of ownership may also transfer such as property tax, insurance and maintenance
Any lease that does not meet the definition of a Capital Lease is an Operating Lease. The lessor (or owner) transfers only the right to use the property to the lessee. At the end of the lease period, the lessee returns the property to the lessor.
The lease payments are treated as an operating expense on the income statement when they are paid and the lease does not appear as an Asset or Liability on the balance sheet.
- Defers lessee expenses in comparison to a capital lease
- The risks of ownership such as property tax, insurance and maintenance may be borne by the Lessor (set in lease contract)
- Returning equipment at end of term allows opportunity to upgrade for technology or capacity
- Does not appear on the Balance Sheet which may be misleading (disclosed only in footnotes to financial reports)