Capital Lease versus Operating Lease
Not all leases must be capitalized (present-valued) and placed on the balance sheet. This treatment is necessary only when substantially all the benefits and risks of ownership are transferred in a lease. Under these circumstances, we have a capital lease (also referred to as a financing lease). Identification as a capital lease and the attendant financial treatment are required whenever any one of the four following conditions is present:
1. The arrangement transfers ownership of the property to the lessee (the leasing party) by the end of the lease term.
2. The lease contains a bargain purchase price at the end of the lease. The option price will have to be sufficiently low so exercise of the option appears reasonably certain.
3. The lease term is equal to 75 percent or more of the estimated life of the leased property.
4. The present value of the minimum lease payments equals 90 percent or more of the fair value of the leased property at the inception of the lease.4
A lease that does not meet any of these four criteria is not regarded as a capital lease, but as an operating lease. An operating lease is usually short term and is often cancelable at the option of the lessee (the party using the asset). Furthermore, the lessor (the owner of the asset) may provide for the maintenance and upkeep of the asset, since he or she is likely to get it back. An operating lease does not require the capitalization, or presentation, of the full obligation on the balance sheet. Operating leases are used most frequently with such assets as automobiles and office equipment, while capital leases are used with oil drilling equipment, airplanes and rail equipment, certain forms of real estate, and other long-term assets. The greatest volume of leasing obligations is represented by capital leases.
Income Statement Effect
The capital lease calls not only for present-valuing the lease obligation on the balance sheet but also for treating the arrangement for income statement purposes as if it were somewhat similar to a purchase-borrowing arrangement. Thus, under a capital lease, the intangible asset account previously shown in Table 16-7 as “Leased property under capital lease” is amortized, or written off, over the life of the lease with an annual expense deduction. Also, the liability account shown in Table 16-7 as “Obligation under capital lease” is written off through regular amortization, with an implied interest expense on the remaining balance. Thus, for financial reporting purposes the annual deductions are amortization of the asset, plus the implied interest expense on the remaining present value of the liability. Though the actual development of these values and accounting rules is best deferred to an accounting course, you should understand the close similarity between a capital lease and borrowing to purchase an asset, for financial reporting purposes.
An operating lease, on the other hand, usually calls for an annual expense deduction equal to the lease payment, with no specific amortization, as is indicated in Appendix 16B, “Lease versus Purchase Decision,” at the end of this chapter.