Whether you are a business owner or bookkeeper, being able to distinguish between a capital lease vs operating lease can save you a lot of money. When it comes to capital leases, business owners can look at them as a more traditional fixed asset finance option. The lease term is anywhere from two to five years. Once this time is over, you will practically own the asset.
An operating lease is on the flip side as there are some noteworthy differences. The way an operating lease works is a business will have different lease options as far as the buyout is concerned. You can compare this lease type with a car lease. Lessees can choose to have 10% or 15% of the price to be due at the end to call the asset their own for goods or return it.
Different tax treatment is another important aspect to understand when comparing capital vs operating lease. With the second lease type, you just use a piece of equipment, vehicle, or anything else you are leasing and deduct lease payments directly from the profit your company is making. Your business is simply renting that piece of equipment, while with a capital lease, a lessee is treated as an owner for tax purposes.
What does capital lease mean?
If you can answer yes to any of the following questions, you are looking at a capital lease agreement.
- Will you become an owner in the end?
- Will you pay less than fair market value to acquire this item?
- Will you lease the asset for 75% (or more) of the time it is considered to be useful?
- Will the payments you make (at present value) cover at least 90% of its fair value?
These points are key elements that define the capital lease. Since the equipment or any other leased item is typically bought out once the agreement comes to an end, this is a good option if you want to own it at the end. This is also the most common reason a lease is viewed as a capital lease by the IRS.
Given the conditions above, it is required that the company presents the leased item as an asset in its accounting records. Think of this type of lease as if you purchased this piece of an asset with a loan. So, lease liability and leased item itself are recorded at a lesser of the present value of minimum payments to the lessor or future monetary value of the asset. Furthermore, the payment is broken down into principal and interest expense. Since the fixed asset is on the lessee’s Balance sheet, it is depreciated over the lease term by the lessee.
In a direct financing lease, the economic motivation for the lessor is simply to earn the interest revenue included in the lease payments. In a sales-type capital lease, the lessor generates two income types: the asset’s fair value is set higher than its book value and the lessor also receives interest as part of the payments on the lease. The lessor treats the asset in its accounting books as if it was simply financing it. The exact value of all future lease payments is initially recorded as a lease receivable. A contra account would be unearned interest revenue.
What is an operating lease?
If you answered no to the above questions, then your lease is classified as operating. The agreement should not provide an option to acquire an item at a bargain price. The PV of lease payments also should not exceed 90 percent of the item’s fair market value.
With an operating lease, the payments go through as a business operating expense, so the leased item is on the lessee’s Balance sheet. Accordingly, the lessee is regarded to be renting the item and therefore the lease payment is considered to be a rental expense.
When it comes to accounting for operating leases by the lessor, the income receipts are recognized as income through profit or loss on a straight-line basis. Depreciation on an asset is claimed by the lessor over its useful life.
Advantages of capital and operating lease
There are several different types of fixed asset financing, so let’s compare capital lease vs operating lease for the lessee, and determine their advantages so you can decide which is better for your company.
Capital lease
- Some of the benefits of a capital lease are that businesses can write off 100% of the cost of the asset in the first year. This gives a huge tax benefit.
- Most capital leases are considered a $1 buyout, so essentially, the business is financing 100% of the asset and owns it after the last payment.
- A good option for start-ups and small businesses that cannot purchase a particular asset right away.
- When filing taxes, depreciation and interest expenses can be deducted from the lessee’s income.
Operating lease
- The best lease option is the frequency of purchasing and having newer equipment under warranty is more important for a business than the tax write-off.
- At the end of the lease, the lessee can hand back or replace the asset or simply extend the lease period.
- The leased equipment, vehicle, or any other asset is off the lessee’s Balance sheet.
The only real disadvantage of this lease option is that a business can write off the payments it makes on that piece of an asset in a year.