Many companies choose to lease assets for a period of time instead of buying them outright. If you’re in this situation, it’s important to know whether you’re dealing with a capital lease or an operating lease. That’s because the type of lease will affect how you record it—and the payments you make to it—in your books.
A few additional differences between capital and operating leases to consider: Capital leases affect your balance sheet, which means they can also impact your covenants and ratio calculations. Also, capital leases allow the leased asset to be capitalized. If an asset is capitalized, it could possibly qualify for an accelerated depreciation option such as bonus depreciation or Section 179, providing you with a larger deduction in the year you sign the lease. Operating leases, on the other hand, require less administrative time to account for them and do not affect the balance sheet.
Not sure if a lease is capital or operating? Here are four questions that can help you determine its classification. If you answer “yes” to any of the questions, the lease is a capital lease. If you answer “no,” it’s an operating lease.
#1 – Is there a transfer of ownership?
If the lease states that your company retains ownership of the leased asset at the end of the lease, it’s a capital lease. In this case, the lease acts as a loan for you to purchase the leased asset.
#2 – Is there a bargain purchase option?
Many leases contain an option to buy out the leased asset at the end of the lease. If this option is less than the expected fair market value of the asset at the end of the lease, it represents a bargain purchase option. Leases that include a bargain purchase option are capital leases. The most common example of this type of lease is a $1 ending purchase option.
#3 – Does the lease period equal or exceed 75 percent of the asset’s useful life?
If the lease in question does not contain #1 and #2 above, the length of the lease is compared to the economic life of the leased asset. If the lease period is equal to or exceeds 75 percent of the leased asset’s useful life, it’s a capital lease. Your company’s capitalization policy should provide guidance on the length of life used for the type of asset being leased.
#4 – Does the present value of the minimum lease payments exceed 90 percent of the asset’s fair market value?
If the lease does not contain any of the above features, the present value of the minimum lease payments should be compared to the fair market value of the leased asset. The present value of the lease payments can be calculated by inputting the total amount of lease payments to be paid over the life of the lease into a present value calculator. The fair market value of the leased asset is equal to its cash price. If the calculated present value of the lease payments is equal to or exceeds 90 percent of the asset’s fair market value, the lease is a capital lease.
What to know about recording the lease and lease payments
Operating leases are simple to record. The payments are recorded each month as an expense in a lease expense account; no asset or liability is recognized on the balance sheet.
Capital leases, however, require the value of the leased asset to be capitalized and recorded as a fixed asset on the balance sheet. This fixed asset is depreciated over time like any other fixed asset purchase. The related lease obligation is also recorded as a liability on the balance sheet and payments are applied to the obligation with a portion segregated for interest expense.
Lease classifications will change in the coming year—stay tuned!
A new lease standard effective for years beginning after December 15, 2019, will change the classification of leases. As this effective date approaches, small business CPA firm, JAK, will provide more information on what you can expect. In the meantime, if you have questions about lease classifications or the new standard mentioned here, please don’t hesitate to call.