Capital Lease vs. Operating Lease: Which Is Better?

Leasing office equipment is a common alternative to buying. Of the two kinds of leases, the operating lease and capital lease, each of them is used for a different purpose and they result in a different treatment on the accounting books of companies. Leasing traditionally is different from purchasing. When you purchase a business asset like equipment or a car, you are buying an asset. When you lease something, you have an expense for the use, but you do not own the property. Two terms that you need to know when looking at leases, the lessor is the seller, the company offering the lease and the lessee is the buyer. 

Capital leases

A capital lease is a lease of business equipment which represents ownership and it is reflected on the balance sheet of the company as an asset. A capital lease, as opposed to an operating lease, is seen as a purchase from the standpoint of the one who is leasing and as a loan from the standpoint of the one who is offering the lease for accounting purposes. 

Capital leases are used for long-term leases and for items that are not technologically obsolete, such as a lot of machines. Capital leases give the lessee the benefits and the drawbacks of ownership, so they are considered as assets and they may depreciate. These leases are considered as the debts of the lessee. In order to be considered a capital lease, the FASB or the Financial Accounting Standards Board requires that at least one of these conditions must be met:

Title to the equipment passes to the lessee by the end of the lease term

The lease contains an option to purchase the equipment at the end of the lease for substantially less than the fair market value

The term of the lease is more than 75% of the useful life of the equipment

The current value of the lease payments is more than 90% of the fair market value of the equipment

If one of these conditions are not met, the lease is an operating lease. With a capital lease, it is like paying the cost of the car over the term of the lease. 

Operating leases

Operating leases are for short-term leasing and they are usually for assets that are high technology or in which the technology changes, like office equipment and computer. They also known as service leases, The rental cost of an operating lease is considered an operating expense. The lessee uses the equipment but does not take on the benefits or drawbacks of owning the equipment which are retained by the lessor. 

Accounting and taxes for leases and lease payments

Operating lease payments are labeled as expenses because there is no ownership of the equipment involved. Capital lease payments reduce the liability of the lease and interest on lease payments is a deductible business expense. 

New accounting rules for leases

The Financial Accounting Standards Board or the FASB issued new accounting rules in 2015 for leases, both operating and capital. The new rules require all the leases to have more than 12 months on the business balance sheet as both assets and liabilities. That is why operating leases of less than a year are treated as an expense, while longer-term operating leases are treated like buying an asset. 

Capital leases and depreciation

Because they are assets, capital leases may be eligible for depreciation. If you want to lease but you want the benefit of depreciating the asset, you can check with your tax adviser before you enter into a capital lease. This is to make sure that it meets the criteria for it to be considered for accelerated depreciation. Some leases may not be eligible for accelerated depreciation. 

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