M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.
Capital Lease or Operating Lease?
Cal is the owner of Calbuild Construction Co. He buys and leases a variety of equipment he uses to build residential housing. Today, he is looking at a new Bobcat he will use to help grade land and carry around lumber. He thinks it is going to get plenty of use and decides to go with a lease. There are two types of leases. An easy way to remember the difference is that a capital lease is like ownership, the item you lease is an asset, and the lease is a liability. An operating lease on the other hand is like renting. No asset or liability is involved, just a monthly expense for the lease payments. When you rent an apartment or house to live in, it is an operating lease.
Cal needs to remember the accounting rules about leases. If any one of these conditions are true, it 'must' be recorded as a capital lease. The conditions are:
- Lease term - The term of the lease is for at least 75% of the useful life of the asset.
- Ownership - Ownership of the asset shifts from the lessee to the lessor by the end of the lease. Cal is the lessor and the equipment company is the lessee in our example.
- Present value - If the present value of the lease payments is at least 90% of the fair market value of the asset.
- Bargain price - The lessor can buy the asset from the lessee at the end of the lease for a below market price (often a dollar)!
Accounting for a Capital Lease
Cal goes ahead and leases the Bobcat from the equipment company. They agree to a five-year lease with payments of $11,000 per year for a total of $55,000. Cal knows that with the wear and tear he will put on the Bobcat, it will have a useful life of no more than 6 years. That means under the lease term rule (lease term is 5 years and asset life is 6, so 5/6= 83% which is greater than 75%), he must book this as a capital lease. Cal goes ahead and signs about 15 pieces of paper and they shake on it.
The team will be excited, Cal though, as they always like getting new equipment to drive around! He takes the stack of paperwork back to the office and hands it to his accountant, Marie. Work this up as a capital lease he tells her, let's see what the numbers look like. Marie returns a few hours later with this table:
The key number is at year 0, that is the net present value of the lease payments, it is $48,970. That will be the amount of the equipment asset and the lease liability when they are entered on the books. The interest portion of the lease payments is reflected in the operating section of the cash flow statement, the principal portion in financing.
Cal looks at the table and smiles, he knows that both the interest and depreciation will be expenses on his income statement that will reduce his income and also his taxes in the early years of the lease. Marie reminds him that she could do those tables a lot faster on a new computer. Cal replies by telling her that the way business is booming that may be sooner than she thinks!
Accounting for an Operating Lease
Accounting for operating leases is much easier since there are no assets or liabilities to book. No net present value of the lease payments is needed. If the Bobcat example is an operating lease, $11,000 per year is entered as lease expense and that is all there is to it! The full amount of the payments is reflected in the operating section of the cash flow statement. The total impact on cash flows is the same for both types of leases. The advantage of operating leases is that the lessee keeps ownership of the asset and bears the cost of maintaining the asset if it needs repairs.
Summary Table for the Two Types of Leases
A capital lease is like ownership, the lessor books both an asset and a liability in the amount of the net present value of the lease payments. An operating lease on the other hand is like renting, no asset or liability is booked. The income statement impact is also different. In a capital lease both interest on the lease payments and depreciation of the leased asset may be recognized as expenses. In an operating lease, only the lease payments are expensed. In a capital lease the risks of ownership and maintenance expense fall on the lessor, while in an operating lease they fall on the lessee. The total cash flow statement impact is the same for both.
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