Liabilities - Capital And Operating Leases

Lease Classification
Note: For clarity, the classification of a lease should be considered on an item by item basis and not grouped together. In addition, the classification should be determined at the time of the commitment or signing of the lease which may or may not coincide with the date that the lessee actually receives the physical asset.

A lessee (the company leasing equipment) should classify a lease transaction as a capital lease if it is non-cancelable and if one or more of the four classification criteria are met:

  • The agreement specifies that ownership of the asset transfers to the lessee.
  • The agreement contains a bargain purchase option.
  • The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset.
  • The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset.

If none of these criteria are met, the lease can be classified as an operating lease.

Choosing Capital and Operating Leases
Most companies will want to classify their leases as operating leases because they can provide a company with the following:

  • Tax incentive
    • The tax benefit of owning an asset (depreciation expense) can be exploited best by transferring it to a party that has a higher tax bracket.
    • A firm with a lower tax bracket will have incentives to classify a lease as an operating lease.
    • A firm with a higher tax bracket will be more likely to classify a lease as a capital lease.
  • Non-tax incentives
    • If a lease is classified as an operating lease no assets or liabilities associated with the lease are recorded on the balance sheet. Since the company's asset base is reported lower the immediate benefit would be a higher ROA than it would display had it classified the lease as a capital lease requiring a higher asset base. It will also allow a company to display better solvency ratios such as debt-to-equity.
    • Operating leases create off-balance sheet financing because no liability is recorded on the balance sheet since no asset is recorded. The result is the company would display to its debt lenders better debt covenant ratios.
    • Some companies link management bonuses to specific ratios such as return on capital which creates even more incentives to lean towards operating classifications.

While there are significantly more incentives to classify leases as operating, there are a few benefits to using capitalization:

  • The lease expenses would reduce net income, thus potentially reducing a company's income tax expense and rates.

  • Operating cash flow will be higher under a capital lease because there is no operating lease expense.
Effects Of Capital Vs. Operating Leases


Related Articles
  1. Economics

    How Does an Operating Lease Work?

    Operating lease is a term used mostly in accounting to denote a lease that gives the lessee rights to use and operate an asset without ownership.
  2. Economics

    What is a Capital Lease?

    A lease considered to have the economic characteristics of asset ownership.
  3. Professionals

    Effects Of Capital Vs. Operating Leases

    CFA Level 1 - Effects Of Capital Vs. Operating Leases. Examines the impact on lease classification on financial statements. Compares the differences between operating and capital leases.
  4. Professionals

    Determining The Value Of The Lease And The Lease Asset

    CFA Level 1 - Determining The Value Of The Lease And The Lease Asset. An in depth look at operating vs. capital leases and their impact on financial statements and ratios. Provides sample calculations ...
  5. Professionals

    Accounting For Leases

    CFA Level 1 - Accounting For Leases. Learn the process of accounting for leases. Explains various criteria a lease must satisfy to become a sales-type or direct-financing lease.
  6. Savings

    Is There a Way to Get Out of Your Car Lease Early?

    For those who no longer want their car for whatever reason, transferring the lease to an interested party can be a particularly appealing choice.
  7. Home & Auto

    When Is Buying A Car Better Than Leasing?

    People who lease a car are often more concerned with the short-term picture.
  8. Savings

    When Is Leasing A Car Your Best Bet?

    Leasing a car isn't right for everyone. But it's attractive for those who want low initial payments and the ability to get a new vehicle every few years.
  9. Savings

    Why You Should Buy A Car Instead Of Leasing

    While leasing has certain advantages, buying a car tends to save you money in the long run and offers greater flexibility.
  10. Professionals

    Buy Vs. Lease/Rent

    Buy Vs. Lease/Rent
RELATED TERMS
  1. Leasehold

    An accounting term used to classify an asset on a company's balance ...
  2. Capital Lease

    A lease considered to have the economic characteristics of asset ...
  3. Operating Lease

    A contract that allows for the use of an asset, but does not ...
  4. Bargain Renewal Option

    A clause in a lease agreement that gives the lessee the option ...
  5. Bargain Purchase Option

    An option in a lease agreement that allows the lessee to purchase ...
  6. Closed-End Lease

    A rental agreement that puts no obligation on the lessee (the ...
RELATED FAQS
  1. Why might a bond agreement limit the amount of assets that the firm can lease?

    Bond covenants can limit the amount of leases a company can have because leasing contracts are a form of debt. Taking on ... Read Answer >>
  2. At the beginning of the year, ABC Corp. began to lease a major piece of equipment ...

    The correct answer is: A) Under the capitalized lease method, the lessee must treat the asset as if it was purchased with ... Read Answer >>
  3. At the beginning of the year, HIJ Corp. began to lease new equipment ...

    The correct answer is: b) Total Lease Payment = Interest expense + Principal repayment Step 1: Interest expense = 8.5% of ... Read Answer >>
  4. You are currently reviewing the following information for JKL Corp ...

    Free info on financial certification exams including study guides, exam questions, and much more! Read Answer >>
  5. How have low interest rates affected lease rates in the automotive sector?

    Find out how and why lower interest rates for leasing new automobiles have helped spur more consumers to lease cars instead ... Read Answer >>
  6. What are the differences between single, double and triple-net leases?

    Learn the ins and outs of net lease agreements, including the key differences between single net, double net and triple net ... Read Answer >>
Hot Definitions
  1. Goodwill

    An account that can be found in the assets portion of a company's balance sheet. Goodwill can often arise when one company ...
  2. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  3. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  4. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  5. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  6. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
Trading Center