There are two kinds of accounting methods for leases: operating and capital lease. A vast majority are operating leases. An operating lease is treated like renting -- payments are considered operational expenses and the asset being leased stays off the balance sheet. In contrast, a capital lease is more like a loan; the asset is treated as being owned by the lessee so it stays on the balance sheet. The accounting treatment for capital and operating leases is different, and can have a significant impact on taxes owed by the business. A capital lease is called a "finance lease" by the IFAC.
Finance vs Operating Lease redirects here.
What is a Lease?
A lease is an agreement conveying the right to use property, plant, and equipment (PP&E) usually for a stated period of time. The party that gets the right to use the asset is called a lessee and the party that owns the asset but leases it to others is called the lessor.
Types of Leases
Various accounting standards recognize different kinds of leases. Standards govern the classification not just the lessee but also for the lessor.
In general, a capital lease (or finance lease) is one in which all the benefits and risks of ownership are transferred substantially to the lessee. The legal owner (the holder of the title) may still be the lessor. This is analogous to financing a car via an auto loan -- the car buyer is the owner of the car for all practical purposes but legally the financing company retains title until the loan is repaid.
Capital Lease Test
How does one choose between capital and operating leases for accounting? In general, companies prefer operating leases. So the Financial Accounting Standards Board (FASB) has imposed some restrictions on which leases can be treated as operating leases. A lease must be treated as a capital lease if it meets any single one of the following 4 conditions:
- Ownership: The lease transfers ownership of the property to the lessee by the end of the lease term.
- Bargain Price Option: The lease contains an option to purchase the leased property at a bargain price.
- Estimated Economic Life: The lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.
- Fair Value: The present value of rental and other minimum lease payments, excluding that portion of the payments representing executory costs, equals or exceeds 90% of the fair market value of the leased property.
The last two criteria do not apply when the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property.
If none of these criteria are met and the lease agreement is only for a limited-time use of the asset, then it is an operating lease.
Accounting for leases: Operating and Capital Lease
Capital and operating leases receive different accounting treatment both for the lessor and the lessee. We will focus on the lessee in this analysis. Under operating lease accounting, the lessee does not own the asset, which has the following implications:
- Lease payments are considered operational expenses for the business.
- The asset/lease is not reported on the balance sheet.
- The firm cannot claim depreciation on the asset.
In contrast, accounting for a capital lease (or finance lease in IFAC terminology) treats the lessee as the owner of the asset, which means:
- The lease is considered a loan. Interest payments are considered operational expenses.
- The asset is included in the balance sheet: the outstanding loan amount (net present value of all future lease payments) is included as a liability, and the present market value of the asset is included as an asset.
- The lessee can claim depreciation on the asset every year.
The FASB and the IASB have proposed some changes to lease accounting rules that would virtually eliminate operating lease accounting treatment for all companies that lease real estate. The changes, proposed in 2012, are expected to take effect in 2015. The proposed standards will require assets and liabilities to be reported related to the lease. To that extent, the leases will be similar to capital or finance leases. But there are some differences in how these assets and liabilities are measured.
Pros and Cons
Advantages of an operating lease
- Operating leases provide much-needed flexibility to companies that frequently update or replace their equipment.
- The lessee is protected from the risk of obsolescence.
- Accounting is simpler: the asset does not have to be included in the balance sheet. The corresponding debt liability does not have to be calculated or included either.
- Lease payments are operational expenses, so they are fully tax deductible.
- It provides improved Return On Asset (ROA) without capital budgeting restraints.
Advantages of a capital lease
- Capital leases recognize expenses sooner than equivalent operating leases. The lessee is allowed to claim depreciation each year on the asset.
- In addition to depreciation, the interest expense component of the lease payment can also be deducted as an operational expense.