Question

Instead of purchasing assets outright many companies lease assets either for operational purposes or as a means of asset acquisition. Please explain the differences between the 2 types of leases, capital and operating, and explain how both the lessee and the lessor view these arrangements and provide a clear discussion of the process each uses to determine whether to enter into a leasing arrangement.

Answer 1

A capital lease (or finance lease) is treated like an asset on a company’s balance sheet, while an operating lease is an expense that remains off the balance sheet. Capital leases are counted as debt. They depreciate over time and incur interest expense.

To be classified as a capital lease under U.S. GAAP, any one of four conditions must be met:-

• A transfer of ownership of the asset at the end of the term
• An option to purchase the asset at a discounted price at the end of the term
• The term of the lease is greater than or equal to 75% of the useful life of the asset
• The present value of the lease payments is greater than or equal to 90% of the asset’s fair market value

Operating leases are used for short-term leasing of assets and are similar to renting, as they do not involve any transfer of ownership. Periodic lease payments are treated as operating expenses and are expensed on the income statement, impacting both the operating and net income.

In contrast, capital leases are used to lease longer-term assets and give the lessee ownership rights.

Accounting Treatment:-

Capital and operating leases are subject to different accounting treatment for both the lessee and the lessor.

Accounting for an operating lease is relatively straightforward. Lease payments are considered operating expenses and are expensed on the income statement. The firm does not own the asset and, therefore, it does not show up on the balance sheet and the firm does not assess any depreciation for the asset.

In contrast, a capital lease involves the transfer of ownership rights of the asset to the lessee. The lease is considered a loan (debt financing), and interest payments are expensed on the income statement. The present market value of the asset is included in the balance sheet under the assets side and depreciation is charged on the income statement. On the other side, the loan amount, which is the net present value of all future payments, is included under liabilities.