A capital lease, also called a financial lease, is a commercial financial agreement. The lessee, such as a company, will select an asset, like a piece of equipment that they need. The finance company, or the lessor, will buy that asset. The company will then use that asset over its life. In the end, the finance company will recover a large part of the cost of the assets plus any interest they have charged on all the rentals paid by the company. The company may have the option to purchase the asset at an agreed upon purchase price.
Operating lease is a lease of a much shorter term, compared to the capital lease, in the full useful life of the asset being purchased. Operating leases are commonly used to acquire equipment for a relatively short-term basis.
EXAMPLEAn aircraft, which has an economic life of 25 years, might be leased to an airline for five years on an operating lease. This is done by the lessor.
This is a good way for the company to outsource industrial equipment. It does not require the company to use equity. At the end of an operating lease, the asset does not pass to the lessee, or the company.
At the end of the operating lease, there are many options:
Leasing will have a significant impact on financial statements during the accounting process in the leasing period.
|Operating Lease||Capital Lease|
Not reported as an asset or liability, so it doesn't appear on the balance sheet
Does appear on the income statement as payments are incurred
Usually appears as rent
Reported on the balance sheet as both an asset and a liability
Appears as an asset as the present value of the rental payments made on the cumulative basis to date
Appears as a liability as an element of long-term debt
Sometimes it is not clear whether a lease is a capital lease or an operating lease.
The lease is considered to be a capital lease if it meets any of these conditions:
Leasing is less capital intensive than purchasing. If a business has constraints on its capital, it could grow more rapidly by leasing property than by purchasing that same property.
Capital assets may also fluctuate in value, so leasing shifts the risks to the lessor, or the financing company. However, if the market for that equipment has shown steady growth over a long period of time, the business could be sacrificing capital gains.
Depreciation of capital assets has different tax and financial treatment from ordinary business expenses. Lease payments can be considered expenses rather than assets, which can be offset against revenue when calculating taxable profit at the end of the accounting period.
In some cases, leasing may be the only practical option.
EXAMPLEA small business may wish to open a location in a large office building with tight location parameters.
Finally, leasing may provide more flexibility to a business that expects to grow or move in a relatively short term because a lessee is not usually obliged to renew a lease at the end of its term.
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “ Leasing” TUTORIAL.