Whether you are aspiring to run your own business, or you are beginning in accounting it is very important to understand the difference between the two major types of leases. Operating leases and capital leases the two main kinds of leases and they play a large role in not only running a business but also the accounting side of a business. The difference between capital and operating lease can have a significant impact on your business costs, taxes, and accounting.
In order to better understand their impact in your business and accounting, it is important to understand what operating leases and capital leases are.
What is an Operating Lease?
An operating lease is a form of contract which allows the lessee to use an asset without the transfer of ownership. An operating lease works similar to renting, payments that are made for the lease of the asset are considered operating expenses. This means that the lease payments are considered as part of the expenses for running the business and the lease is not mentioned on the balance sheet.
Accounting for operating lease is generally simpler as the company or business does not own the asset. The operating lease payments are expensed on the income statement and it remains off the balance sheet. As the equipment or asset is not owned by the business they do not have to account for depreciation.
The advantages of Operating leases
There are many advantages of an operating lease and depending on what you plan for business operations and for accounting you can use these to your benefit.
- One advantage of operating lease is the flexibility that they provide. As a business doesn’t own the asset, it is easier to replace or upgrade the equipment of asset. Newer, more advanced versions, or even a variation of the equipment can usually be exchanged in an operating lease.
- There is no chance for the equipment or asset to become obsolete as it is not owned by the business. The lessor is still the owner, which will make them less inclined to make their equipment obsolete.
- Accounting for an operating lease is a lot simpler as it is only mentioned in the income statement as an expense and no depreciation needs to be calculated.
- Lease payments are tax deductible which means that a business can claim the amount of the lease in their taxes for as an expense for running their business.
What is a Capital lease?
A capital lease is a type of contractual agreement in which the lessor allows temporary use of an asset to the lessee and in this form of lease for accounting purposes the asset is considered under ownership of the lessee. A capital lease functions more like a loan and is treated in terms of being owned by the renter. Hence, a capital lease is mention on the balancing sheet and the business must calculate depreciation on the asset.
As many businesses would prefer operating leases, there have been some regulations put in by the GAAP (Generally Accepted Accounting Principles) for what constitutes a capital lease.
If any one of the following 4 conditions are met, then a lease is considered a capital lease:
- If the asset is transferred in ownership to the renter at the end of the leasing period.
- The lessor provides the lessee an offer to purchase the asset at a discounted price when the term of the lease is over
- If the term of the lease covers 75 percent or more of the asset’s useful life span
- The present value of the payments for lease cover 90 percent or more of the asset’s fair market value
If any of these conditions are met, then the lease is considered a capitol lease under the GAAP. This means the asset must be mentioned on the balance sheet, its fair market value under the assets and the net loan amount under liabilities.
The Advantages of a Capital Lease
There are still certain advantages of a capital lease that a business can take advantage of.
- The depreciation of the asset can be claimed by the lessee which is advantages as it will reduce the amount of taxable income. So even though the extra work of calculating the depreciation has to be done it is beneficial as you can claim it in taxes.
- Another advantage of a capital lease is that the interest expense can also be claimed in taxes. So, the interest expense is tax deductible, which lowers the tax payable for the business.
Operating Leases Vs. Capital Leases
Ownership of the asset
Operating Lease: Ownership of the asset is maintained by the lessor during and after leasing period.
Capital Lease: Ownership of the asset may be transferred to the lessee at the end of the leasing period.
Discounted or bargain purchase offer of asset
Operating Lease: The lease cannot contain an offer or option to purchase asset at discounted price.
Capital Lease: The lease can contain an offer to purchase the asset at a bargain price that is less then the fair market value
Length of Lease term
Operating Lease: The term of the lease is less than 75 percent of the asset’s useful life
Capital Lease: The length of the lease term is equal to or more than 75 percent of the asset’s useful life
Operating Lease: The present value of the lease payments of the asset is less than 90 percent of the fair market value
Capital Lease: The current value of the lease payments is equal to or more than 90 percent of the asset’s fair market value
The Bottom Line (Capital Lease Vs Operating Lease)
Capital leases are counted as debt. Capital Lease is depreciating over time and incur interest expense.
To be classified as a capital lease under the U.S. GAAP, any one of following conditions must be met:
- A transfer of the ownership of the asset at the end of the term
- An option to buy the asset at a discounted price at the end of the term
- The term of the lease is greater than or equal to 75% of the useful life of the asset
- The present value of the lease payments is greater than or equal to 90% of the asset’s fair market value
Alternatively, if evaluated under IFRS, there is one more criterion that could be used to qualify a lease as a capital lease:
- The assets under the lease are specialized so that only the lessee is able to utilize them without big changes being made to the assets
Operating leases are usually used for short-term leasing of assets and are similar to rent, as they don’t involve any transfer of ownership. Periodic lease payments are always treated as operating expenses and are expensed on the income statement, impacting both the operating and net income. In contrast, capital leases are used to lease long-term assets and give the lessee ownership rights.
In conclusion Capital lease vs operating lease are differentiated based on the ownership of the asset at the end of the lease, the offer for a discounted purchase, value of the lease payments, and the length of the lease. The operating lease is only mentioned on the income statement whereas the capital lease is mention on the balance sheet as well.
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