Capital lease / Operating Lease
A lease is an agreement under which the original owner of property permits someone else to use it. The original owner is the lessor and the user of the property is the lessee. There are many kinds of leases and subtleties to lease contracts, but the major distinction to be aware of is the difference between operating leases and capital leases.
Operating vs. Capital Leases
FASB-13 ruling on Operating vs. Capital Leases
Operating vs. Capital Leases
An operating lease is similar to a rental contract: The lessee pays fees for the life of the lease and simply uses the goods (e.g., a computer system). The lessee reports these costs as operating expenses (and thus lowers taxes in this way), but takes no depreciation expense. The lessor (owner), however, can claim depreciation expenses and take tax benefits. When the lease is over, the lessee surrenders the property (or renews the lease, or perhaps has an option then to purchase outright). Operating leases differ from rental contracts, primarily in that leases are more binding (have greater penalties for early cancellation), and usually cover longer terms. However, an operating lease generally covers a time period significantly less than the expected life of the leased goods.
Capital leases are more like financed purchases, that is, the lessee may immediately gain some of the benefits of ownership, such as charging depreciation expense (and taking tax benefits from that), and recognize the asset on the balance sheet as a capital asset. In the United States, the distinction capital and operating leases is based on the Financial Accounting Standards Board, Statement 13.
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FASB 13 Ruling on Operating vs. Capital Leases
The United States Financial Accounting Standards Board statement 13 (FASB 13) provides the definitions and criteria for deciding whether or not a lease agreement is to be considered a purchase/sale agreement (and therefore a capital lease) or a usage agreement (and therefore an operating lease). The distinction between capital and operating leases has important financial consequences: it determines who (lessor or lessee) has ownership rights and who takes depreciation for the leased goods, who can treat lease costs as expenses, and other factors.
For proper explanation of FASB 13 criteria and usage, consult a leasing guide or financial textbook. Very briefly, FASB 13 states that a lease will be considered an operating lease (usage agreement) unless one or more of the following four criteria are met. If any of the following applies, the lease is then treated as a capital lease (purchase/sale agreement):
- The lease automatically transfers ownership of the property to the lessee by the end of the lease.
- The lease contains a bargain purchase option.
- The lease term equals 75% or more of the estimated economic life of the property.
- The present value of the minimum lease payments at the beginning of the lease term equals or exceeds 90% of the fair market value of the property.
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