Understanding the Different Accounting Treatments of Capital Leases and Operating Leases
Wondering which lease you should be using to secure your assets?
As you already know, the alternative to purchasing equipment is leasing it. There are two kinds of leases that are used to accomplish this: capital leases and operating leases. Each is used for a different purpose, and also looks different on the accounting books.
A capital lease is likened to owning property, and an operating lease as renting it. There is a significant difference between the two. Let’s guide you through these two choices so you can understand their different treatments.
What is a Capital Lease?
A capital lease is considered debt, which depreciates over time and incurs interest.
When it meets the following conditions, the lease becomes a capital lease:
- When ownership is transferred at the end of the term
- When there is the option to purchase the equipment at a lower price at the end of the term
What is an Operational Lease?
An operating lease is a short-term lease that is, essentially, like renting (there is no transfer of ownership). Because lease payments are made, leasing is approached as an operating expense and is shown on the income statement. That’s what differentiates it from a capital lease. An operational lease is used to lease long-term assets and gives the lessee ownership rights.
Capital and operating leases are treated differently on the accounting books.
Putting down a capital lease is a lot trickier than when done for an operating lease. Lease payments are operating expenses and are counted as expenses on the income statement. Because the business doesn’t own the asset, it doesn’t show up on the balance sheet.
A capital lease is a transfer of ownership rights from asset to lessee, the lease is a loan, and interest payments are shown as expenses on the income statement.
What is the advantage of a capital lease?
There are various advantages to a capital lease. Let’s explore three of these:
- The lessee can claim that the asset is depreciating, thereby reducing taxable income
- Interest expense works to reduce taxable income
- Companies in a higher tax bracket are far more likely to place a lease under a capital lease classification
The Advantage of an Operating Lease
There are several advantages to an operating lease. Here are a few:
- Operating leases are more flexible, because they can replace or update their assets more often
- Doing the accounting becomes easier for an operating lease
- You can deduct taxes off the lease payment
Different businesses use these two leasing methods. This makes it important to understand how to do the accounting as well as the tax treatments for these for both the owner and the lessee.
These two types of leases come with their own advantages. Depending on the requirement and tax circumstance, as a business owner, you may opt for one or the other.