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Examine the similarities and differences between capital leases and operating leases.

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[MUSIC PLAYING] This is Dr. Bob Nolley. In this lesson, we'll take another look at an option available for long-term capital financing. This is leasing.

There are two types of leases. There's the capital lease, also called a financial lease, and the operating lease. Let's look at these two.

A capital lease is a commercial financial agreement. The customer, the company, will select an asset or a piece of equipment that they need. The finance company, the lessor, will buy that asset. The company then will use that asset over its life. And in the end, the finance company recovers a large part of the cost of the assets plus any interest they have charge on all the rentals paid by the company.

The company may have the option to purchase the asset at an agreed upon optional purchase price. An operating lease is a lease of a much shorter term compared to the capital lease and the full useful life of the asset being purchased.

Operating leases are commonly used to acquire equipment for a relatively short-term basis. For example, an 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.

And it's a good way for the company to outsource industrial equipment. It does not require the company to use equity. At the end of the operating lease, the asset does not pass to the company, but they can return the equipment, or renew the lease, or renew the equipment, or purchase the equipment at a market value agreed upon.

Now let's consider the accounting impact of leasing on a company's financial statements. Leasing will have a significant impact on financial statements during the accounting process in the leasing period. An operating lease is not reported as an asset or a liability, so it doesn't appear on the balance sheet. It does appear on the income statement as payments are incurred. It usually appears as rent.

On the other hand, a capital lease is reported on the balance sheet, both as an asset and a liability. It appears as an asset as the present value of rental payments made on the cumulative basis to date. It also 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-- if the company gains ownership of the asset at the conclusion of the lease, if the company is offered a bargain purchase contract at the end of the lease, paying less than market value, if the life of the lease is equal to or greater than 75% of the estimated life of the asset, or the present value of the minimum lease payments is equal to, greater than 90% of the market value of the leased property.

Any one of these criteria being met considers the lease a capital lease. And it will impact the asset liabilities on the balance sheet. Otherwise, it's seen as an expense and is filed as an operating lease on the income statement.

Let's take a look at the advantages of leasing. Leasing is less capital intensive than purchasing. So 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 this risk to the lessor, the financing company. But if the market for the equipment has shown to be steadily growing over a long period of time, the business could be sacrificing potential capital gains.

Depreciation of capital assets has a different tax and financial treatment from ordinary business expenses. Lease payments can be considered expenses rather than assets when they can be offset against a revenue when calculating your taxable profit at the end of the accounting period.

In some cases, at least, leasing may be the only practical option for a small business who may wish to open a location in a large office building with very 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.

Now let's review these points about leasing. Leasing is another method for companies to achieve long-term capital investment. A capital lease or a financial lease has a financing company purchasing an asset required by a business. The business makes payments for the full economic life of the equipment.

An operating lease is a lease whose term is shorter compared to the economic life of the piece of equipment. At the end of the operating lease, the title does not pass to the lessee but remains with the lessor, the financing company.

Accounting impacts are different for these two types of leases. A capital lease is reflected as both an asset as a liability on the balance sheet based on the present value of lease payments made to date. An operating lease has payments shown as an expense in the accounting period in which they are made.

Advantages of leasing include being less capital intensive than purchasing, the deferral of value fluctuation from company to the lessor, potential favorable tax impacts from operating leases whose payments are shown as expenses, being a flexible source of financing for small businesses as they may expect to grow and move in the short-term.

This is Dr. Bob Nolley. And I'll see you in the next lesson.


Terms to Know
Capital Lease

A lease that is usually quite long, perhaps even the entire duration of the life of the asset being leased; it has balance sheet implications, as the asset itself may be transferred at the end of the contract.

Operating Lease

A lease that is usually short compared to the life of the asset being leased, and does not result in a change of ownership at the end of the lease.