What Is The Difference Between An Operating Lease And A Capital Lease?

Operating lease vs. capital lease. Which one should you consider for equipment leasing and what is the difference?

operating leaseMany businesses choose to lease long-term assets instead of buying them for a number of reasons. First, leases offer more flexibility, they allow for equipment upgrades and they offer a number of tax benefits as seen in section 179 of the IRS tax code. There are a number of different types of leases to choose from but only two of them are common: the operating lease and the capital lease. Each of the two leases are used for different purposes and have different accounting treatment in the accounting books.

Capital Leases

If you plan to lease long term equipment, then you should use a capital lease. Long term equipment should be equipment that does not require frequent maintenance or upgrades. This is typical of many kinds of machinery such as farm equipment, construction equipment, trucks, etc.

Capital leases give you the benefit of ownership as well as drawbacks. Since they are considered as assets, they can be depreciated. Many at times you will hear a capital lease being referred to as a debt. There are certain requirements that a lease must meet in order for it to be considered a capital lease. According to FASB, a lease is considered a capital lease when:

  1. If the lease payments made from the beginning of the lease term are more than 90% of the equipment’s fair market value
  2. If the lease term is equal to or exceeds more than 75% of the equipment’s estimated economic life
  3. If the lease has a buyout option
  4. If ownership of the equipment is transferred to you after a certain amount of lease payments are made or at the end of the lease period.

An Operating Lease

For a lease to be classified as an operating lease, the lease expenses must be considered as operating expenses. More importantly, the lease should not be included as a portion of the firm’s capital. Operating leases are sometimes referred to as service leases because they are used for short term leasing. They are most suitable for businesses that prefer to lease assets that rapidly depreciate such as computers and other technological equipment.

Unlike in a capital lease, you do not get to own the equipment at the end of the lease or after making a certain amount of lease payments. Ownership of the equipment always remains with the lessor.

Operating Lease Vs. Capital Lease: Which One Is Better?

This depends on what the immediate and long term goals are for your company. If you plan to lease high tech equipment, then you are better off choosing an operating lease; if you plan on leasing equipment that you intend to use for a very long time, then you are better off with a capital lease.

Should You Extend Your Operating Lease?

If you can’t return the equipment (because you still have operational needs for it), then you may have no choice but to extend your operating lease. You should be extremely cautious of the language used when negotiating lease agreements regarding lease extensions.

The following are the consequences of extending your lease if you do not minimize the risks:

1. The Cost Of Extending The Lease Has To Be Included In The Budget

When you choose to extend your lease, it might play havoc on your budget cycles. If your cash flow is very tight, it might limit ongoing capital expenditures.

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2. The Income Statement Suffers

Lease extensions are just additional costs, which keep showing up on your expense line. If you do not put a cap on it, it could go on forever, dragging down the profitability of the company.

3. The Cost Of Your Transaction Increases

Extending your lease dramatically escalates the overall cost of your lease making it a less effective cost saving strategy for your business. Any savings you expected to make from leasing the equipment will automatically be eliminated.

Avoid Lease Extensions

As a company, you should be able to recognize your own limitation to negotiate favorable lease terms. Lease agreements are very complicated documents and if you do not have in-house experts to review and structure the lease to protect you from lease extensions, you could enter into a very costly transaction.

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