Comparing Capital Lease vs Operating Lease
Leasing machinery or vehicles by businesses is a common practice used as an alternative to buying. There are two different leases — capital and operating. These two leasing types have different effects on taxes and accounting. Keep reading the article to find out more about the topic.
Equipment Lease
Businesses prefer lease equipment and vehicles for a variety of reasons:
- To maintain positive cash flow.
- To get finance.
- To keep machinery up to date without loan to purchase.
- To preserve the capital.
A lessee gets an asset with the Right of Use (ROU) in all leasing types. According to the contract, the lessee also gets a liability that requires them to make regular payments.
Under capital leasing, a leased asset is treated as a purchase in taxing and accounting and added to a company’s balance sheet. On the contrary, an operating lease is treated as a true lease under GAAP rules.
Capital Lease
As mentioned, a capital lease (or a finance lease) is represented in accounting and taxing as a purchase, not as a traditional lease. The benefits and liabilities are transferred from the lessor to the lessee according to the contract.
A capital lease is added to the balance sheet as an asset in accounting. Regular payments reduce the liability for the lease. The interest on these payments can be deducted as a business expense.
Financial Accounting Standards Board (FASB) state that to be a capital lease, it must meet a minimum one of these requirements:
- The contract has an option allowing a lessee to buy the asset at the end of the contract at a bargain price. Meaning the price should be significantly lower than the fair market value. It’s common to buy assets under this rule for $1.
- The ownership is transferred to the lessee by the end of the contract.
- The present cost of total lease payments does not exceed the 90% rate of the asset’s fair market value.
- The term of the contract has to exceed 75% of the asset’s useful lifespan.
In simple words, when signing this type of contract, the business is paying the asset’s cost during the entire duration of a contract.
The IRS recognizes a capital lease when its amount is $50,000 or more, and the asset’s useful lifespan is at least two years. It must also meet the criteria described in the previous paragraphs.
Since the IRS sees a capital lease as an asset purchase, the leased asset can be eligible for depreciation. If a business is considering leasing an asset, they should discuss if the asset can be depreciable.
Specific assets don’t fall under the category of accelerated depreciation, so be careful when deciding what type of lease to choose.
Advantages and Disadvantages
Here are some advantages of signing the capital leasing agreement:
- Getting ownership of an asset at the end of the lease term.
- Claiming depreciation.
- Reducing the taxable income.
The agreement also has several disadvantages:
- The lessee is tied to the asset for the duration of the contract.
- The asset may become outdated by the end of the contract.
Some businesses prefer operating leasing because of the flexibility in renting updated equipment. However, many companies prefer capital leases because of the depreciation they can claim.
Operating Lease
Under operating leasing, the lessee and the asset owner write down a contract. According to the agreement, the lessee does not own the asset because the asset’s owner transfers only the right to use the asset. At the end of the contract, the lessee must return the asset to its owner.
The business does not add the leased asset to the balance sheet in accounting. However, the accountant should add regular payments to the business’s profit and loss statement.
In taxing, operating lease payments work similarly to interest payments on debt. A business must report the operating lease as operating expenses in the business tax form when filing taxes.
It’s worth mentioning that under operating leasing, a business must return the asset in the same condition and values as when it was leased.
Advantages and Disadvantages
Here are some of the common advantages of operating leasing:
- The lessee can use a short-term agreement to benefit from leasing the most updated equipment.
- Easier to record in accounting.
- It’s possible to deduct payments on the accrual basis of accounting.
As for the disadvantages, there is only one. The lessee won’t get ownership of the asset by the end of the contract. But businesses that need updated equipment do not consider the inability to get ownership of an asset a disadvantage.
Capital Lease vs Operating Lease: Key Differences and Similarities
Here are some differences between these two types of leasing agreements:
- The ownership of an asset under capital leasing is transferred to the lessee. Under the operating leasing contract, the lessor keeps the asset’s ownership.
- Under capital leasing, a lessor may purchase the asset at a bargain which is not possible when signing the operating leasing contract.
- The capital leasing agreement contains a requirement that the term of a contract should be 75% or more of the useful lifespan. According to operating leasing, the term has to be less than 75% of the asset’s estimated economic lifespan.
- Under capital leasing, the current value of total payments equals or exceeds 90% of the asset’s original value. According to the operating leasing agreement, the value of payments is lower than 90% of the asset’s fair market value.
- The owner of the asset transfers all risks and benefits to the lessee under the capital leasing contract. But according to operating leasing, the owner only transfers the right to use the asset.
- According to the capital lease contract, the lessee is an owner of an asset and can pay taxes to claim depreciation accordingly. If signing an operating leasing agreement, the lessee is renting the equipment, so it’s a rental expense.
Capital and operating lease agreements also have a few similarities. Both agreements involve renting equipment for business purposes. Both agreements have to be recorded in accounting in financial statements.