Many small and medium businesses opt for a long term leases rather than buy the equipment they need. This is done for a variety of reasons; it offers more flexibility than a loan, less down payment, and offers more options in term of adjusting to changes in technology and business needs.
Lease payments are no different than loan payments and should be viewed as such. If a business is allowed to keep the leased equipment off its financial statements, a look at those statements will give a misleading view of the business financial strength. Therefore, accounting rules have been adjusted to force businesses to reveal the extent of their lease obligations.
There are 2 ways you can account for leases:
Operating Lease – the lessor transfers only the right to use the equipment or property. At the end of the lease period, the equipment goes back to the lessor. Since you do not assume the risk of ownership, the lease expense is treated like an operating expense in the income statement and the lease has no effect on the balance sheet.
Capital Lease – You assume some of the risks of ownership and can reap some of the benefits. The lease is recognized as an asset and a liability – the lease payments – on the balance sheet. You get to claim depreciation each year and also deduct the interest expense payments of the lease amount.
In short: capital lease recognizes expenses sooner than the operating lease.
Since most businesses prefer to keep leases of the books, or defer expenses, there is a strong motivation to report all leases as operating leases. To combat that, The Financial Accounting Standard Board has decided that a lease should be considered a Capital lease if it meets those conditions:
• The lease life exceeds 75% of the life of the asset.
• If there is a transfer of the ownership at the end of the lease
• If there is an option to purchase the asset at “bargaining price” and the end of the lease
• If the present value of the lease payments exceeds 90% of the fair market value.
When classified as an operating lease, the lease expenses are treated as operating expenses and do not show as part of the capital of the business.
If it is classified as capital lease the present value of the lease is treated like debt and the interest is credited and shown as part of the income statement.
Practically, reclassifying operating lease as capital lease can increase the debt shown on the balance sheet.