Focus on Leasing: Capital vs. Operating Lease
One topic that rarely comes up when speaking to clients about leasing options is capital vs. operating leases — a very important consideration. These are the two types of leases, and each has its own accounting treatment. The major difference between them is that capital leases transfer ownership of the leased product, while operating leases only transfer the right to use the technology.
Choosing the correct lease structure is critical because it affects how your finance department records the lease on your books.
Capital leases are reported on your balance sheet and operating leases are not. Even if you are a privately held company your finance team still keeps good accounting records and communicates on a regular basis with your major creditors.
The most important concept to understand about a capital lease is the word capital, as in cash or credit. The accounting treatment of a capital lease is similar to an outright purchase. As the lessee, you are obligated to report a capital lease as an asset and a liability on your balance sheet. As such, your organization may claim depreciation on the assets.
- In a capital lease, your organization only assumes some of the risks of ownership. The lessor (leasing company or bank) purchases an asset on your behalf.
- The lessee (you) will have use of the asset during the lease term.
- You make rental payments (including tax and interest) to the lessor that covers a large portion or all of the original cost of the asset.
- Your organization records the capital lease on balance sheets as an asset and a liability.
At the end of term, you have many options available. You may choose to purchase the asset outright, return the asset to the lessor, or extend the term of the lease and continue to make payments. At the end of the lease, if you choose to purchase the asset, the cost to take ownership may be low, sometimes as low as $1. Keep in mind that a capital lease does not imply $1 out; a capital lease may have a fair market value (FMV) buyout. A FMV buyout may be cost prohibitive. Capital leasing is a creative way to acquire a bundle of technology products and services over a period of time. This option may be more attractive than using a bank credit line or paying cash.
Capital leasing is a creative way to acquire a bundle of technology products and services over a period of time. This option may be more attractive than using a bank credit line or paying cash.
The most important concept to understand about an operating lease is the word operating, as in operating expense. In an operating lease, only the right to use the technology is transferred from the lessor to the lessee. When leasing IT products and service, it is harder to qualify for an operating lease due to the increased risk the lessor takes on.
Operating Lease Requirements (Statement of Financial Accounting Standards - FASB 13)
- The lease does not transfer ownership of the property to the lessee by the end of the lease term
- The lease does not contain a bargain purchase option (unlike the capital lease, where you are often able to purchase the asset at lease end).
- The lease term is equal to less than 75% of the estimated economic life of the property.
- The present value of the minimum lease payments, assuming an appropriate discount rate must be less than 90% of the fair value of the property at lease inception.
Operating Lease Basics:
- The lessor (leasing company or bank) purchases an asset on your behalf.
- The lessee (you) have use of the asset during the lease term.
- You make rental payments (including tax and interest) to the lessor, which only covers the use of the asset for the term.
- Your organization records the operating lease as an operating expense on income statements.
At the end of term, the lessee has many options available to them. The lessee can choose to purchase the asset outright, return the asset to the lessor, or extend the term of the lease and continue to make payments. At the end of the lease, if you choose to outright purchase the asset, the cost to take ownership can be very high. The FMV in a operating lease cannot be pre-negotiated. Hence, operating leases are a creative way to utilize a bundle of technology products and services over a period of time, typically followed by a refresh of the technology. Extending the lease term typically converts the lease to a capital lease for the new term. This option may be more attractive than capital leasing, using a bank credit line, or paying cash.
Applying Leasing to IT Projects
As an IT decision maker, you need to know your organization's preferred accounting treatment for leases. Knowing how your organization prefers to account for leases will affect your strategy when evaluating lease options.
For example, if your organization prefers operating leases:
- You probably will not find a 60-month operating lease for PCs, laptops, printers, or other IT products, because the lease life would exceed 75% of the useful life of the asset and payments would exceed 90% of the present value of the asset.
- You will be limited as to how many services dollars (soft costs) are wrapped into the lease, because services are not tangible and cannot be recovered by the leasing company, and payments would exceed 90% of the present value of the asset.
- You will most likely refresh your technology products and service at the end of the term because buyouts are based on fair market value and can be very cost prohibitive, and your money factor may require you to return all of the assets at the end of the lease.
- You cannot negotiate the residual value of the assets to be leased because the lease cannot contain a bargain purchase option and the low residual values may cause your payments to exceed 90% of the present value.
If your organization prefers capital leases:
- You can choose a longer lease term sometimes as long as 72 months for IT products and services
- Leasing may be a better way to make payments than using a bank line
- Easier to get approved for a capital lease than a new bank line
- You can bundle a lot of services into a capital lease
- There are no restrictions regarding the present value of the equipment
- May provide a way to finance services of a specific term
- You can negotiate your lease payment and residual value (FMV or $1 out)
- No restrictions regarding a bargain purchase option
- Creative way to keep your monthly lease payments low
Did you recently make a leasing decision after considering both capital and operating lease options? Which did you choose? What affected your decision?
Focus on Leasing Topics:
- Leasing Vocabulary
- Financing Decisions
- Advantages of Leasing
- Capital vs. Operating Leases
- Understanding My Payment
- Picking a Lease Partner
- The OEM Lease
- Interest-Free Leasing
- Managing Lease Schedules
- Managing the End of Lease Process
Jeffrey Goldstein is Senior Consultant at MCPc and is responsible for the delivery of hardcopy and value added services within the Lifecycle Management Group. Jeff earned his BS in Management of Information Systems and Supply Chain Management from The University of Akron and his MBA from the Weatherhead School of Management, Case Western Reserve University. Connect with Jeff on LinkedIn.