The most common types of leases you will come across as a business owner or an accountant are operating lease and capital lease. Before we do capital lease vs operating lease comparison, let’s first consider what makes businesses go for lease? Leasing protects the interests of both parties. It contains information on how much the item costs at the moment, the amount lessee would need to pay to use the asset and how long it can be used for. So, why is leasing is often a preferred option in business, despite the cash outflow, which eventually covers (2-3 times) the cost of a one-time purchase of an object?
The fact is that the leased object is typically expensive and requires large capital investments. It is typically more profitable to not take a bank loan with an interest for its purchase, but to lease the asset. In addition, not every business is able to take a large loan because the financial institutions do not want to give a loan for various reasons or the business wants to maintain a specific financial image before its investors. Thus, management often chooses to lease the asset. Next, we will look at the capital lease vs operating lease and key differences that make management choose one over the other.
The business that would lease the asset not only gets to use the assets, but also receives all the associated risks and rewards of owning this fixed asset. The lessor is only legally considered the owner of the leased item.
The lessee is much better off in this case because it only rips the benefits of having access to the asset for a period of time specified in the agreement and not worrying about the risks associated.
With most assets, you have a risk that they will become obsolete at some point in time, so it would not make sense to use the item anymore. The lessee would bear this risk as it is almost the owner of the asset.
If the fixed asset is no longer salable or useful, it would be the lessor that would suffer the losses associated with the asset’s obsolescence.
The capital lease agreement is typically non-cancellable by either party.
This lease agreement is not set in stone and can be canceled relatively easily, especially if the lessor has another party desiring to lease the same asset.
The lessor only uses its capital to initially acquire the asset, while all the repairs and maintenance required are done by the entity that actually uses it.
Operating lease is more advantageous when it comes to maintenance and all the possible repairs because the lessor would be responsible for keeping its asset in a good condition.
The key aspect in the capital lease vs operating lease comparison is that in the first case, the lessee ends up paying the full cost of the asset plus the interest, which is why the item is often transferred to the lessee on very favorable terms at the end of the lease. In a way, it is an installment purchase by the lessee.
The lessor recovers the cost of the item by leasing the item to multiple lessees numerous times over its useful life. Thus, the lessee pays only a small portion of the asset’s cost and typically leases the object for a shorter period of time in comparison to the financial lease.
It has been long recognized that capital leases are financing arrangements in disguise, which is why it is often referred to as a financial lease. Accordingly, businesses are required to treat such leases as if they were loans, which removes one of its big advantages.
The present value of the cash payments for the lease is capitalized and recorded as an asset. Each payment is allocated between interest and principal. The asset account is debited and the Lease Payable account is credited. Depreciation is recorded on leased assets. Operating lease payments, on the other hand, are recorded as an expense by the lessee and as revenue by the lessor. A great example of such a lease type is car rental.
The lease would be recognized as capital if:
- The ownership rights are passed down to the lessee in the end;
- There is a possibility to buy the leased object;
- All the payments the lessee will make at their present value add up to at least 90% of the item’s value;
- The object will be lease to one entity for at least 3/4th of its useful life.
If the company is not required to follow U.S. GAAP standards, then the conditions for classifying the lease as capital are slightly different. International standards consider any lease of an asset is considered capital only if the object would require significant changes to be used by another lessee.
In an operating lease, the asset is on the Balance sheet of the lessor and amortized in accordance with its accounting policies. Therefore, the lessor bears significant risks and rewards. Rental income is not discounted. The rent paid by the lessee is considered to be a current rental expense and is included in the expenses in accordance with the rental income scheme. The cost of repairing the object is determined by the agreement of the parties.
In a financial or capital lease type, the company uses the leased objects to produce, sell, and receive revenue, but also takes the burden of depreciation, repair, etc. In this case, the object is the property of the lessor, and the lessee only possesses it. Of course, the latter can buy the object at the end of the lease term, but before that, it is obliged to pay the entire rent to the lessor, i.e. actually pay for the rental object.
Author: Charles Lutwidge