Operating Leases Vs. Capital Leases
By: Gardiner Thomsen CPAs | email
Based on questions that we have received lately, it appears that leasing is a favorable way of acquiring assets for some of our clients. The decision to lease is based on specifics such as: better financial terms, necessity, the lack of available financing, or just the desire to keep assets off the balance sheet. In any case, whether the lease is treated as an operating lease, the decision should be dependent upon the terms of each individual lease agreement.
Under general accounting rules, leases are classified as:
So, how do you decide what type of lease you have? From the lessee’s perspective, a lease would be a capital type lease if it meets at least one of the following criteria:
- Capital lease – a lease which transfers most of the benefits and risks of ownership to the lessee, and is recorded as if the lessee borrowed the money to purchase the property.
- Operating lease – a lease that is not classified as a capital lease and is thereby treated as the rental of property by the lessee. Costs are recorded as consideration is paid.
Some of the tests or criteria are more complex than others. If necessary, please contact us for assistance in determining the correct classification of leases in your financial statements. Should you decide to enter into leasing arrangements in the future or if you would like help in analyzing proposals you may receive regarding leasing opportunities, we’re here to assist you!
- Ownership transfer. If the lease pass’s title to the lessee by the end of the lease term,and transfers all the benefits and risks of ownership, then it is a capital lease.
- Bargain purchase option. This is an option for the lessee to purchase the leased property at a price substantially below its fair value at the end of the lease term.
- 75% Test. This test is met if the fixed, non cancelable portion of the lease term is at least 75% of the estimated remaining economic life of the leased property.
- 90% Test. If the present value of the minimum lease payments is at least 90% of the property’s fair value at the inception of the lease.