An operating lease is a rental agreement which is substantially shorter than the useful life of the asset and is cancelable by the lessee (Yap, 2002). At the end of the lease agreement, the lessor can either lease the equipment to someone else or sell the equipment secondhand. A capital lease is long term and non-cancelable. According to Wagner and Hall (1991), a capital lease represents agreements that satisfy at least one of the following criteria:
Title passes to lessee at conclusion of lease term
Contract includes bargain purchase option
Lease term is at least 75 percent of equipment・s estimated useful life
Present value of
minimum lease payments is 90 percent or more of the fair vale of the leased
Leasing is simply an alternative type of financing. According to Capital.Com (2001), there are advantages of leasing. First, the company・s capital is not tied up in a depreciating asset. Leasing allows the asset to be paid for as it generates revenue. Secondly, the company incurs fixed regular payments so it is easier for cash flow arrangement. Thirdly, there is a smaller upfront expenditure and no need to pay for equipment before it adds to the bottom line. Fourthly, leasing certain equipment offers tax advantages. Often times a lease can be written off as a monthly expense. But when equipment is purchased with cash or a loan, the company must depreciate the asset. Finally, the risk of obsolescence is on the leasing corporation so the company can defer the decision to buy the equipment. Hence, leasing provides a non-conflicting source of credit and leaves current credit lines open for other uses.
Both operating and capital leases appear on the income statement as tax-deductible expenses. However, a capital lease is functionally equivalent to the acquisition of a fixed asset through the assumption of a liability similar to debt or mortgage. The information should therefore show up on the company・s balance sheet. That is, the lessee must record the fixed asset and the related liability at the present (discounted) value of the future lease payments. The fixed asset is then subject to amortization, for example depreciation. Lease payments are treated as payments for interest and liability amortization.
The accounting impact of capital lease is increasing the level of debt on the books, which influences the performance of key financial ratios, such as debt to equity, return on assets, etc. The worse the financial looks, the more difficult the company gets needed financing in the future. On the other hand, operating lease obligations are referenced in the footnote section of the financials and not in the balance sheet as assets and liabilities (Leasing Ideas, 2000). Given reasonable alternatives, most companies will opt for structuring equipment lease transactions to meet the accounting criteria for operating lease treatment.
(2001), ．Types of Financing・, [Online, accessed 24 February 2003]
(2000), Lease Accounting Issues, [Online, accessed 20 February 2003]
Wagner, William B
and Hall, Patricia K (1991), ．Equipment Lease Accounting in Industrial Marketing
Strategy・, Industrial Marketing Management, Elsevier Science Publishing Co
Inc, New York, [Online, accessed 25 February 2003]
Yap, Kim Len (2002), Corporate Bonds, Preferred Stock and Leasing, Prentice Hall
Back to Accounting and Finance Article List