Businesses need financial assistance to run their day-to-day operations. Leasing is one way for them to manage their finances. There are numerous advantages of leasing, including no upfront payments for assets and the availability of higher-quality equipment. There are typically two types of leases: capital lease and operating lease. Both differ in structure, accounting treatment and taxation.
Table of Contents
What is a capital lease?
A capital lease is the lease of any business equipment or property by a lessor to a lessee. The lessor agrees to transfer ownership of the asset to the lessee once the lease period is over.
Leasing is different from buying. When you buy an asset, you take ownership of the asset upon payment. When you lease an asset, you pay leasing fees but don’t own the property, yet.
In a capital lease, ownership is passed to the lessee on completion of the lease period. The lease acts like a loan for the asset by the lessor to the lessee and is considered part of the lessee’s debt.
What can be leased?
Assets that are typically leased include aircraft, land, buildings, vehicles, heavy equipment, ships etc.
Why do companies lease?
Leasing is a common alternative to purchasing. When companies have limited funds to purchase an asset, they may lease.
The four criteria of a capital lease
To be classified as a capital lease under US Generally Accepted Accounting Principles or US GAAP, any one of the following four conditions must be met:
- Transfer of ownership of the asset at the end of the term
- Option to purchase the asset at a discounted price at the end of the term
- Term of the lease is greater than or equal to 75% of the useful life of the asset
- Present value of the lease payments is greater than or equal to 90% of the asset’s fair market value
Capital lease versus operating lease
There are two kinds of leases: capital lease and operating lease. Each is used for different purposes and is treated differently in accounting.
An operating lease is an agreement to use and operate an asset without the transfer of ownership. An operating lease is like renting, while capital leases are considered purchases.
As such, leasing payments under an operating lease are booked as operational expenses and the asset stays off the lessee’s 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 lessee’s balance sheet.
Capital leases are usually used for long-term leases and for items that don’t become obsolete very fast, such as machinery.
Operating leases, sometimes called service leases, tend to be used for short-term leasing of less than a year. They are often used for assets that are high-tech or where technology changes quickly, like computers and office equipment. Businesses with operating leases likely don’t wish to keep the assets over the long term.
Pros and cons of leasing
- Businesses that lease do not need to get a loan or tie up their funds to buy assets. Leases thus add flexibility to their businesses.
- A lessee can claim depreciation deductions, reducing itstaxable income. Interest expense deductions can also reduce its taxable income.
- Risk of obsolescence. There is a risk that the lessee will be stuck with obsolete assets during the time of the lease.
- Maintenance responsibilities. The lessee has to bear all repair and maintenance costs of the asset during the period of the lease.
Accounting treatment of capital lease
A capital lease involves the transfer of ownership of the asset to the lessee at the end of the lease. The lease is thus considered a loan and interest payments are expensed on its income statement. The asset is also included in the lessee’s balance sheet, where the outstanding loan amount is included as a liability and the present market value of the asset is included as an asset.
In an operating lease, lease payments are considered operating expenses and are expensed on the lessee’s income statement. The lessee does not own the asset and therefore, the asset does not show up on its balance sheet. There is also no depreciation for the asset.
Frequently Asked Questions
The advantages of a capital lease include:
- The lessee is allowed to claim depreciation on the asset, which reduces its taxable income
- Interest expense also reduces its taxable income
The advantages of an operating lease include:
- Operating leases provide greater flexibility to companies as they can replace or update their equipment more often
- No risk of obsolescence, as there is no transfer of ownership
- Accounting for an operating lease is simpler
- Lease payments are tax-deductible
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