Capital Lease vs. Operating Lease: Which Is Right for You?

Leasing is a cost-effective way to acquire the use of a fixed asset without purchasing the asset outright. But you must be cautious before entering into a lease agreement. Not understanding the differences between a capital lease and an operating lease can be costly.

You might be confused about the differences between a capital lease vs. an operating lease. Maybe you are wondering which lease option is best for your business. Or maybe you already have a lease and you are confused about how to record it in your accounting.

Whatever your questions, read on for a detailed explanation of all things pertaining to these two different types of leases and how your lease terms can impact your business.

Capital Lease vs. Operating Lease: What Kind of Lease Do You Have?

You can determine what kind of lease you have by asking yourself four questions:

• Will you own the leased item at the end of the lease term? It’s not uncommon to lease an item—like a photocopier or a high-grade coffee maker—for several years. This doesn’t automatically mean you will ever own the photocopier or coffee maker, though.
  
  If there is no transfer of ownership at the end of the lease agreement, then the lease is an operating lease. If you will own the item at the end of the agreement—in other words, if you have a lease to own arrangement—then the lease is a capital lease.
  

• Is there an option to purchase the item at the end of the lease term? Sometimes, you won’t own the item you are leasing outright at the end of the lease term, but you might be given the option to purchase the item for a bargain price, or less than the fair market value of the item.
  
  If you have an option to purchase the item you are leasing at the end of the lease term for less than the current value of the item, then your lease is a capital lease. This option to purchase and the purchase amount will be spelled out in the terms of your lease. If it isn’t, then your lease is an operating lease.
  

• Does the lease last for at least 75% of the item’s estimated useful life? The life of a leased asset can be several decades (in the case of a building or heavy equipment) or it can be just a few years. The IRS has established rules for determining the useful life of assets.
  
  If the term of your lease lasts at least 75% of the useful life of the item, then your lease is a capital lease. If the lease is for a shorter term than 75% of the life of the asset, then it is an operating lease.
  

• Is the present value of your lease payments greater than 90% of the item’s fair market value? Your lease might be for a small percentage of the fair market value of the item leased. For example, you might be leasing an office building valued at $3 million for 60 months at $5,000/month. Although the value of your lease is $300,000—not an insignificant amount of money—it is only 10% of the fair market value of the building.
  
  On the other hand, you might be leasing an automobile valued at $36,000 for 36 months at $910/month. The value of your lease is $32,760—91% of the fair market value of the automobile.<
  
  The building lease would be an operating lease, but the automobile lease would be a capital lease.

Capital Lease Accounting vs. Operating Lease Accounting

Although they aren’t technically loans, capital leases are treated much like loans in a business’s accounting. The steps for recognizing capital leases in your accounting are as follows:

1. When you acquire the leased item, you debit a fixed asset account and credit a liability account called Capital Lease Payable.
2. Payments on the lease credit your checking account and debit the Capital Lease Payable liability account for the portion of the payment that is not interest.
3. Any interest or finance charge on the lease is recorded as an expense by debiting an interest expense account.
4. Depreciation is recorded either monthly or annually by debiting a depreciation expense account and crediting an accumulated depreciation asset account.

Accounting for operating leases is typically easier, because most operating leases last 12 months or less and payments are simply recorded as expenses on your P&L. When you make your lease payment, you will debit a lease or rent expense account and credit your checking account.

There is a new rule that might impact how you handle the accounting for your operating leases, though.

Accounting Changes for Operating Leases

You might have heard talk about the changing standards for recording leases in accounting. As with any changes to accounting standards, there has been confusion about what these changes mean and in which situations they are applicable.

If your business leases assets from another company—in other words, if you are a lessee—then how you record leases in your accounting is changing. In an Accounting Standards Update issued in February 2016, the Financial Accounting Standards Board (FASB) released new guidance for lessees. These changes provide more transparency to those reading a company’s financial statements.^[1]

Publicly traded companies must start adhering to the new rules for fiscal years beginning after December 15, 2018; privately traded companies have a bit longer, until December 15, 2019.

What Are the Changes?

The new FASB guidance states lessees must recognize assets and liabilities for all leases with terms of more than 12 months. This applies to both capital and operating leases—a change from long-standing generally accepted accounting principles (GAAP), which only required the capitalization of capital leases.

If you have an operating lease that lasts longer than 12 months, your accounting will now look like this:

1. When you acquire the leased item, you debit an asset account called Operating Lease Right of Use Asset and credit a liability account called Operating Lease Payable.
2. Payments on the lease credit your checking account and debit a combination of Operating Lease Payable and an expense account called Lease Expense. There will also be a debit to the Operating Lease Right of Use Asset account to offset the portion of the lease which has been fulfilled.

The exact proportions of the credits and debits in step 2 depend on a number of factors and will vary from lease to lease. It is important to check with your accountant or bookkeeper for their advice regarding how to record operating leases lasting more than 12 months under the new standards in your accounting.

It is important to note your operating lease payments will still be recognized as an expense on your P&L, regardless of whether your operating lease must be capitalized.

A Note for Lessors

If you are a lessor instead of a lessee—meaning you are in the business of leasing assets to others—then how you handle your accounting for leased equipment is mostly unchanged by the 2016 Accounting Standards Update.

Capital Lease vs. Operating Lease: Which Option Is Best?

Now that you know the difference between a capital lease and an operating lease and how to record each in your accounting, you are probably wondering which lease option is best for you.

As usual, the answer is a solid, “It depends.”

Capital Lease Benefits and Drawbacks

A capital lease allows you to use the leased item for an extended period of time and then offers you the option to purchase the item for less than its current fair market value. This “try it before you buy it” approach can be more appealing than committing to a large purchase outright, because you have the option to walk away at the end of the lease without the hassle of selling the asset. And capital leases are more appealing than a typical rental agreement, because you do have the option to acquire ownership of the item at the end of the lease term.

Since capital lease payments effectively reduce a liability owed to the lessor, they aren’t tax-deductible expenses on your P&L. However, the interest on capital lease payments is a tax deductible expense, and you can also often depreciate a leased asset, which can save you money on your taxes.

There are some drawbacks to capital leases, though. It’s not uncommon to spend more money on lease payments than you would spend purchasing an asset outright or under a traditional loan agreement. Under a capital lease, you also take on the risks of ownership—meaning if the asset needs repair, you will have to pay for that repair. And some leases aren’t eligible for depreciation allowances on your taxes, so check with your tax adviser if depreciation deductions are part of your tax-savings strategy.

Operating Lease Benefits and Drawbacks

Operating leases allow you to essentially “rent” equipment—like photocopiers—that might be too expensive to purchase outright. Repairs and maintenance on equipment leased under an operating lease is often covered by the lessor, which can be appealing if the equipment has significant maintenance requirements or will be subject to heavy use and therefore more prone to breakdowns. And operating lease payments are tax deductible as expenses on your P&L.

Some business owners dislike operating leases, though, because they will never actually own the leased equipment. And—as is the case with capital leases—you might end up paying more for the lease than you would if you purchased the asset outright.

Leasing: Another Option for Business Growth

Leasing can be a cost-effective way to acquire the assets you need to facilitate the growth of your business. Both capital and operating leases are typically more flexible than traditional loans, and they often don’t require a large down payment at the commencement of the lease term. This can be appealing if your cash flow is tight.

Leasing can be expensive, though, and—depending on the type of lease you have—you might lose out on some of the tax benefits that can come from directly purchasing an asset or purchasing an asset using a traditional loan.

Because of the potential drawbacks of leasing, you should consider talking with your accountant prior to entering into a lease agreement. Now that you understand more about the different types of leases available, with the help of your accountant you will be able to make a more informed choice about the option that is best for you.

Article Sources:

1. FASB.org. “FASB Issues New Guidance on Lease Accounting“