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. Managing Wealth

    What is a Capital Lease?

    A lease considered to have the economic characteristics of asset ownership.
  2. Investing

    Uncovering Hidden Debt

    Understand how financing through operating leases, synthetic leases, and securitizations affects companies' image of performance.
  3. Personal Finance

    When Is Buying A Car Better Than Leasing?

    People who lease a car are often more concerned with the short-term picture.
  4. Managing Wealth

    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.
  5. Managing Wealth

    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.
  6. Retirement

    Retirees: Should You Buy or Lease Your Car?

    To buy or lease – that is the question. For retirees, access to safer cars, comprehensive warranties and tax deductions may drive up leasing's appeal.
  7. Investing

    New Wheels: Lease Or Buy?

    These two major ways to obtain a car have very different advantages and drawbacks. Find out which is best for you.
  8. Personal Finance

    Auto Leasing Hits Record High in Q4

    Auto Leasing is continuously growing in popularity as a preferred choice of financing.
  9. Managing Wealth

    4 Ways to Get the Best Deal on a Car Lease

    Car buyers typically negotiate when purchasing a vehicle, but many don't negotiate when leasing a car. There are several ways to save if you ask.
  10. Managing Wealth

    Your Lease Is Up: When Should You Buy The Car?

    In general, the fact that you know the car is to your benefit. Before deciding, compare the buyback price to what the car would go for on the open market.
Frequently Asked Questions
  1. Why is social responsibility important to a business?

    Take social responsibility seriously, and your business could benefit from happier, more productive staff members while helping ...
  2. Which socially responsible retailers appeal most to ethical investors?

    Learn why ethical investors have many options in the retail sector, and discover which retail companies are most popular ...
  3. What are Some Examples of Free Market Economies?

    Learn which of the world's economies best resemble free market economies, marked by free trade, low government involvement, ...
  4. Who Decides When to Print money in India?

    Find out the role of the Reserve Bank of India, or RBI, and the amount of authority given to the government. Learn who is ...
Trading Center