Capital Leases vs. Operating Leases

Many companies at some point lease an asset as an alternative to purchasing the asset out right, sounds straightforward right. accounting can get a bit more complicated and the two alternatives for accounting treatment are substantially different. The accounting treatment for capital and operating leases is as follows: Capital Lease: The company is required to book the asset they are leasing as a capital asset and also recognize a liability on their financial statements for the lease obligation.

The only expense recognized is an interest component for each payment made. Operating Lease: The company doesn't book an asset or a liability and the full value of the lease payments are expensed during each period.

So how do you know what kind of lease you have?

There are four criteria set out in FAS 13 and if any of the four tests are met you are required to book the lease as a capital lease and show the asset and liability. The four criteria are:
  1. Does the leased property transfer to you at the end of the lease?
  2. Does the lease have a bargain purchase option at the end of it, whereby you can purchase the asset at a price significantly less than what the asset will be worth?
  3. Is the life of the lease more than 75% of the expected useful life of the asset?
  4. Is the present value of the lease payments stipulated more than 90% of the fair value of the asset right now?
If you answer yes to any one of the questions above, you have a capital lease. The only out is if the lease is for less than 12 months, in that case itâ s not accounted for as a lease at all and the payments are simply considered rental expenses.

Accounting for a Capital Lease

Operating leases are straightforward in that you simply expense the payment, but if you have a capital lease and now need to book an asset, a liability, and an expense it gets a bit more complicated. The asset and liability that need to be booked are booked at the present value of the lease payments, though a caveat is that this cannot exceed the fair market value of the actual asset. Each year, or period accounted for, an interest expense will be recognized by multiplying the interest rate by the lease obligation outstanding. This will be considered the interest portion of the payments made, with the remaining amount of the payment being applied as a reduction in the lease obligation liability that was booked. The asset will be reduced each period by amortizing it as you would any other asset the company has recorded.

So what does this mean to me?

For companies looking at leasing assets you need to consider how it will impact your financial statements and the impact that will have on your different financial metrics. Companies that have loan covenants on their debt to equity ratio may need to ensure leases are structured to be classified as operating, in order to avoid taking on the extra balance sheet debt. Knowing that before hand is important, as going offside of a loan covenant simply because you didn't fully understand your lease accounting could be a disaster.

Lease Accounting Changes

In order to bring US GAAP more in line with IFRS the accounting for leases will be changing, with a target date for implementation of 2016. The changes will effectively eliminate operating lease accounting and going forward all leases will be accounted for under the capital lease format discussed above.

Lease Accounting for the Lessor

For the lessor the capital lease vs. operating lease distinction is also important. Under an operating lease the lessor will retain the asset on its balance sheet and simply book the lease payments received as revenues. Under a capital lease the lessor will remove the asset from its balance sheet and replace it with a receivable for the present value of the minimum lease payments. Payments received would reduce the receivable and the only revenue booked would be the interest component (similar as discussed above).
By Jeffrey Glen

Copyrighted 2020. Content published with author's permission.

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