A lease is an agreement giving the lessee the right to property, plant, and equipment usually for a stated period of time (according to FASB).
Capital leases essentially mean a purchase. Capital leases are used for long term assets, and for assets that don’t become technologically obsolete. Operating leases are rentals, and are mostly used for short-term leasing, for high tech equipment, or for assets in which the technology changes often, and include office copiers, computers, automobiles, and trucks.
Advantages of Leasing over Purchasing
- Since the lessee doesn’t have ownership, the lease expenses are treated as operating expenses and shows up on the income statement, completely bypassing being classified as a liability on the balance sheet.
- No down payment. Most purchases of equipment require a down payment, in case of default. Leasing may be an attractive option if, say,a company is a start up on a tight budget, a company doesn’t have the cash for a down payment, or a firm wishes to use available funds for other operating or investing purposes.
- Avoids the risks of ownership. These would include obsolescence, changes in capacity needs and changes in market values. If leased equipment that becomes obsolete, simply terminate the lease, (usually with a penalty) and lease new equipment. If the market value of an asset decreases, again terminate the lease; otherwise, the lessee will be stuck with it when market values decline.
Advantages for the Lessor to Lease
- Increased sales. Since some customers may be unwilling or unable to purchase equipment, a manufacturer can increase sales by offering the leasing of its products.
- Residual value (another name for salvage value) is maintained. In many leases, title is never passed to the lesser. If economic conditions improve, the lessor will benefit from increased salvage value at the of the lease term. The lessor can then lease the asset to another lessee or sell the equipment outright for an immediate gain.
Criteria for a Capital Lease
Since there is a strong incentive for firms to report all leases as operating leases, FASB has developed four tests that apply to both lessor and lessee in determining operating or capital lease status. If any of the four are met, it is considered to be a capital lease. For lessors, the revenue recognition test must be met as well.
- Title Transfer: Was there a transfer of ownership?
- Bargain Purchase Option: Does the lessee has the right to buy the asset in the future, and the price is less than the fair market value at that date?
- Is the lease term equal to or more than 75% economic life of the asset?
- If, at the beginning of the lease term, does the present value of the minimum lease terms equal or exceed 90% of the leased asset? (Here you will have to calculate the present value of the minimum lease terms. Use the Present Value of an Ordinary Annuity Table, or the Present Value of an Annuity Due Table).
- Revenue Recognition. There is no doubt that the lessee can make all the payments, and there are no hidden charges.
The copyright of the article Capital and Operating Leases in Accounting is owned by Bruce Silver. Permission to republish Capital and Operating Leases in print or online must be granted by the author in writing.
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