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Today we’re discussing the distinction between capital leases and operating leases.
As mentioned in an earlier blog, most equipment leases are actually financing arrangements in disguise. The accounting profession has long recognized this, and has issued pronouncements that require that certain leases be treated as if they were loans.
These leases are referred to as capital leases. Generally, it is a capital lease if it meets one of the following four conditions: 1) the lease life exceed 75% of the life of the asset, 2) there is a contractual transfer of ownership to the lessee at the end of the term, 3) there is an option to purchase the asset at a bargain price at the end of the lease term, or 4) the present value of the lease payments, discounted at the company’s incremental borrowing rate, exceeds 90% of the FMV of the asset.
If your lease meets these criteria, the equipment must be capitalized, meaning, it must be presented on the balance sheet as if were a purchased asset, and depreciated like a purchased asset. The lease liability must also be set up at its present value on your balance as if it were a loan.
You will need to consult a qualified professional to make sure that your leases are properly accounted for. To learn more about leases, visit our video library at www.cfooutsource.com.