Accounting for leases may sound a bit like a CPA being a stickler for detail, but proper accounting for leases can impact the financial books as well as have tax implications. In general, the difference between an operating and a capital lease in terms of these effects are the following:

  • Higher debt with a capital lease
  • Higher total assets with a capital lease
  • Lower income and lower retained earnings with a capital lease. This is due to the interest expense being higher in the earlier years of the lease, which will decrease income. While the total charges to the company may be the same over the lease term whether accounting for the lease a capital lease or operating lease, the charges for a capital lease are higher in the earlier years and lower in the later years. And if an accelerated method of depreciation is used instead of straight-line, the difference between the two methods would be even larger.
  • The debt to total equity ratio increases with a capital lease and the rate of return on total assets decreases. Many view this as a negative impact on their financial position.
  • In terms of tax impact, if your taxable income is high enough to support it, then in the earlier years of the lease, the higher interest expense and depreciation will give you lower taxable income and reduce your tax burden.

And here is how you decide which type of lease it is!

Capital Lease
A capital lease is one that needs to be capitalized! What this means is that the leased asset will be listed on your books as an asset, and full liability of the lease will be listed as a liability. Testing for a capital lease is straightforward. If it meets one of the following 4 criteria, then it is a capital lease.

  • The lease transfers ownership of the asset to the lessee.
  • The lease contains a bargain-purchase option, which means the lease allows the lessee to purchase the leased property at a price significantly lower than the expected fair value at the exercisable option date. At the start of the lease, the difference between the option price and the fair value must be large enough to reasonably assure exercise of the option. For example, assume you are leasing a piece of equipment for $599 for 40 months, with an option to buy it for $100 at the end of the lease. If the estimated fair value at the end of the 40 months is $4000, then $100 is definitely a good bargain and would be almost a no-brainer that the option to purchase would be exercised.
  • The lease term is equal to 75% or more of the estimated economic life of the leased property. If it is, then most of the risk and rewards of ownership have been transferred to the lessee. Sometimes it is tough to determine the lease term and economic life, however. For example, if the lease contains a bargain renewal option, the lease period can be extended. Like the bargain-purchase option, if the difference between the renewal rental and the expected fair rental is big enough, it’s very likely the option to renew will be exercised. For example, if your initial lease rate is $200/month and then, after three years, your rate will drop to $25/month for another three years, then the lease term would be considered 6 years instead of 3. If the economic life of the equipment was less than or equal to 4.5 years (75% of 6 years), then this would be a capital lease.
  • The present value of the minimum lease payments (excluding executory costs that are included in the lease) is greater than or equal to 90% of the fair value of the leased property. This tests whether the lessee is effectively purchasing the asset. Note that minimum lease payments include minimum rental payments, guaranteed residual value (if any), penalty for failure to renew or extend the lease, and bargain purchase option (if any). Executory costs include insurance, maintenance and tax expenses. The discount rate used is the lessee’s incremental borrowing rate, or lessor’s implicit interest rate if it is less than the lessee’s incremental borrowing rate.

Operating Lease
If none of these four criteria above are met, then the lease is an operating lease and should be treated as rental payments.

Accounting Entries

The easiest is an operating lease (let’s assume $500/month):
(DR)Rent Expense $500
(CR)Cash $500

Capital lease
Assume the following:
Lease Term = 5 years
Annual payments = $25,981.62
Economic life = 5 years
Executory costs (property tax) = $2000/yr
Fair value of equipment at inception = $100,000
Incremental borrowing rate = 10%

At the outset, let’s say Jan 1, 2015, the capitalized amount is equal to $100,000 which is the present value of the minimum lease payments ($25,981.62-$2000)*PV factor (4.16986) = $100,000:

(DR)Leased Equipment (under capital leases) $100,000
(CR)Lease Liability $100,000

With the first lease payment:
(DR)Property Tax Expense $2,000.00
(DR)Lease Liability $23,981.62
(CR)Cash $25,981.62

With each lease payment, the interest is on the outstanding liability. So at the end of the 1st year (12/31/2015), you would record:
(DR)Interest Expense $7,601.84
(CR)Interest Payable $7,601.84

and account for depreciation (assume straight-line, $100,000/5 years):
(DR)Depreciation Expense (capital leases) $20,000
(Cr)Accumulated Depreciation-Capital leases $20,000

At the beginning of Year 2 (1/1/2016):
(DR)Property Tax Expense $2,000.00
(DR)Interest Payable $7,601.84
(DR)Lease Liability $16,379.78
(CR)Cash $25,981.62

Continuing in this manner, at the end of the lease, the equipment has been fully depreciated, so you move the equipment and accumulated depreciation to different accounts, removing the lease from your books:
(DR)Equipment $100,000
(DR)Accumulated Depreciation-capital leases $100,000
(CR)Leased Equipment (under capital leases) $100,000
(CR)Accumulated Depreciation-Equipment $100,000

So, again I ask, are you accounting for your leases correctly? If you need some help or more clarity, please give us a ring!