Why do firms choose to lease their assets instead of buying them? Why do some companies go for capital lease and others for an operating one? Is it because of the taxes? In this piece, we will be trying to answer all of these questions and shed some light on the ongoing debate of capital lease vs operating lease.
Capital Lease vs Operating Lease
The majority of companies, with some few exceptions, elect to lease or borrow their long-term assets, rather than buying them directly. This idea might sound like a bit of a surprise to you, but it actually makes a lot more sense. Here’s why. First of all, you’ve guessed it, it’s the taxes. The tax benefits are better for the lessor, or the person who leases than for the lessee or the person, company in our case, who borrows.
The second primary reason why firms choose to rent rather than to buy is flexibility. When we’re talking about long-term assets, this typically means equipment and properties. It’s something that you, as a company, plan on using for a very extended period. Therefore, it’s only logical to lease it rather than buy it whole.
In this way, when technology advances, and it will, it is going to be a lot easier to simply end the leasing contract for your current machines. You can then move on to newer and better ones instead of selling them. Think about the fact that you might not even find buyers for older equipment. Technology is evolving so fast and is becoming so cheap that no one might want them. All of a sudden, leasing sounds like a fantastic idea, doesn’t it?
What to Know
One thing you must know about leases is that they create a type of obligation similar to paying interest on a debt. As a consequence, you must treat it in the same way, with as much seriousness. If a particular company manages to lease a lot of its assets and keeps it from the record, then we have an interesting audit situation. A combing through all the statements will never be able to reveal how powerful that company is from a financial point of view.
This concept is the real reason why all accounting rules say that firms can and will be forced to reveal just how much of their assets they leased over time. It’s the essence of any audit of this kind, in fact.
Capital Lease vs Operating Lease – The Difference
Building on the above, there are currently two ways to which one can account for a lease – the operating and capital lease. Here is what they’re all about.
- Operating lease is a type of agreement between the lessor and the lessee. In this case, the first grants the latter only the right to use the long-term assets. When the contractual time is up, the lessee will, evidently, have to give back whatever it is they borrowed.
Given the fact that the renter never assumes the risk of actually owning the assets, accountants treat the lease expense as an operating one. That happens when it comes to the income statement. Therefore, the lease will never affect the company’s balance sheet.
- The capital lease is the other type. As opposed to the operating lease, in this case, the lessee does share some of the responsibility of owning the long-term assets. However, alongside the lesser, he also enjoys some of the benefits.
This idea translates into the fact that the lease then becomes both a liability and an asset as far as the balance sheet is confirmed. The company in question will then get to claim depreciation every year that passes over the asset. It can also deduct the interest expense as far as the lease payment is concerned each year.
What Documents Say
As mentioned above, many firms choose to keep their leases away from official books. They also like to defer some of the expenses. Therefore, the Financial Accounting Standards Board decided that every lease should be viewed as a capital lease. That should happen as long as it meets one or more of the criteria that follow.
- If the duration of the lease is equal to or surpasses 75 percent of the asset’s life.
- Should there be a transfer of ownership, in the meantime, between the lessor and the lessee.
- If the lessee has the option of buying the asset at what they call a ‘bargain price’ when the lease ends.
- In case the present value of the payments linked to the contract, surpasses 90 percent of the correct market value of that asset. If and when they discount it. Needless to say, the discount rate needs to be appropriate.
5 Essential Facts for the Lessor
1. The Lessor Needs to Use The Same Criteria to Assess If a Lease Is Capital or Operating
He also needs to account for it. Therefore, here are the situations that arise from a tax point of view in the capital lease vs operating lease confrontation.
2. Record Values
Should it be a capital lease, the lessor will record the current value of all future cash flows as if they were revenue. He will also recognize the expenses. The lease receivable will appear on the balance sheet as an asset. Therefore, the interest revenue will get recognition as having been paid over the lease’s term.
As far as the taxes go, the lessor will then claim the tax benefits for the asset they lent. As long as it is an operating lease, of course. However, you should know at this point that, in this situation, the revenue code will use different criteria. That is for determining if the lease in question truly is an operating one.
3. Classify Leases
When and if they classify a lease as an operating one, the lease expenses become operational as well. Therefore, the operating lease will not appear as being part of the company’s capital. If it is a capital lease, then the value of its expenses will have the same rules and regulations as a debt.
Therefore, it’s time we talked about interest. The reason is that, in the capital lease vs operating lease battle, this concept is also important.
The interest then becomes a part of the income statement. However, if we were to bring all this theory into the practical, you should know the following. When attempting to reclassify an operating lease as a capital one, you can increase the amount of debt that you can see on the balance sheet.
Not only that, but you can enhance it in a considerable manner. This happens mostly for companies in sectors that play with great operating leases. Two examples include airlines and the industry of retailing.
5. How the Payments Go
Another thing you need to know is that the lease payments for an operating lease are just as committing as the ones for a capital lease or as the interest you need to pay for a debt.
Let’s say that you, as the lessee, will not take ownership of whatever it is you are leasing. That does not mean that you mustn’t treat it as such. For the time being, it is just as important.
To the Sum
Here is one final idea on the capital lease vs operating lease challenge tax wise. Transforming the operating lease expenses into some equivalent debt is pretty straightforward. The lease payments for future years when it comes to operating leases should receive a full discount. That can happen by using the rate which reflects their status.
This means that they are a type of debt which is quite insecure and risky, at the same time. If we were to approximate, we could say the following. If you use the company’s existing cost of debt before tax as the rate of discount, you could get quite a fair estimate of how much the operating lease is actually worth.