There are essentially two categories for leases based on accounting practices, providing different financial benefits–the operating lease and the capital lease.
THE OPERATING LEASE
The operating lease terms provide the lessee (the company holding the lease), acquisition of the vehicle(s) under the lease for only a small portion of its useful life and usually used for short-term periods. With this lease, the vehicle(s) are returned at the end of the agreement terms to the lessor.
Preferred among most commercial enterprises, the operating lease can be treated as an off balance sheet transaction due to the company’s limitation in risks from ownership of the vehicle(s). This is allowed given that the operating lease meets the criteria of the Financial Accounting Standards Board Statement #13 (FASB #13 PDF). Therefore, the lessee is able to treat the lease payments as an expense on the income statement, with the lease obligation footnoted on the balance sheet disclosure, and is able to gain significant financial tax benefits since the lease does not affect the balance sheet.
There are further definitions of an operating lease – open-end and closed-end leases. Find out more.
THE CAPITAL LEASE
The capital lease places ownership on the lessee, where the terms of the lease cover more than 75% of the estimated life of the vehicle(s) covered under the lease. This lease usually contains an option to purchase the vehicle(s) for less than the fair market value.
Since the lessee assumes some risks of ownership, there are other financial benefits. The capital lease provides an arrangement where the vehicles under the lease are reported as assets for the lessee, and the lease payments are listed on the balance sheet as corresponding liabilities. The lessee is able to claim depreciation each year on the asset and deduct interest expense of the lease payments.
CAPITAL LEASE CRITERIA
The lease needs to meet any one of the following four conditions to be defined as a capital lease.
- Legal ownership of the asset automatically transfers to the lessee at the end of the term of the lease.
- The lease agreement contains a bargain (i.e. substantially below market value) purchase option.
- The lease term is equal to or greater than 75% of the asset’s economic life.
- The present value of the minimum lease payments is equal to or greater than 90% of the fair market value of the asset at the inception of the lease.
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