Meaning of leased asset
Leased assets are those assets that are leased by the owner to another party in consideration of money or any other favor. While leasing the asset, the owner enters into an agreement that allows the other party to make use of the asset temporarily. During the term of the lease, the leased asset remains the property of the lessor or manufacturer.
These assets are not relevant for determining the value of the asset portfolio of the lessee from a legal and taxation standpoint. However, in a few countries, these can be capitalized leased assets that would depend on the type of financing. There are two types of lease i.e. capital lease and operating lease.
Capital lease and its accounting treatment
To qualify as capital lease, one of the following criteria should be met:
- Ownership criteria: The ownership of the asset is shifted from the lessor to the lessee by the end of the lease period
- The option of Bargain buy: The lessee can buy the asset from the lessor at the end of the lease term for a below-market price
- Lease term: The period of the lease encompasses at least 75% of the useful life of the asset (and the lease is noncancelable during the time of lease
- Present value criteria: The present value of the minimum lease payments required under the lease is at least 90% of the fair value of the asset at the inception of the lease.
A capital lease is some sort of rental agreement between lessee and lessor. However, GAAP treats it as a purchase of assets if it meets certain conditions as laid above. Further, capital lease affects the lessee’s financial statements including interest expense, depreciation expense, assets, and liabilities.
In contrast, a capital lease involves the transfer of ownership rights of the asset to the lessee. A capital lease is therefore considered like loan or debt refinancing with interest expensed on the income statement.
The present value of lease payments is related to the cost of the asset which is a fixed asset and recorded with the equivalent amount to the capital lease liability account. With each monthly payment done, the lessee, the lessee shall record a decline in the capital lease liability account and a corresponding charge to interest expense.
The lessee also records a periodic depreciation charge to gradually reduce the carrying amount of the fixed asset in its accounting records. The lease payment comes in the income statement. The lease payment does include the interesting part which needs to be recorded separately. On the other side, the loan amount, which is the net present value of all future payments, is included under liabilities.
Advantages of capital lease
- Under a capital lease, the lessee expenses the depreciation which helps to reduce tax obligation.
- Interest expense is charged to the income statement. This also helps in savings of tax
Operating Lease and its accounting treatment
All other leases than capital lease is termed as operating lease.
Accounting for an operating lease is relatively straightforward. Under the operating lease method, rent expense and the associated liability accrues each day to the lessee as he uses the property. The lessee assigns rent for the periods to benefit from the use of the asset.
This completely ignores any commitments to make any future payments. Further, the lessee makes required accruals or deferrals as required if the accounting period ends before the cash payment dates of the lease agreement.
Operating lease does not have any impact on the balance sheet of the company as they are short term types of lease. Operating lease payments are operating expenses and hence, shown under the income statement. The lessee does not meet the ownership test under an operating lease. This is the reason the asset does not appear under the balance sheet. Further, no depreciation needs to be charged under such a scenario.
Advantages of operating lease
- Operating leases provide more flexible options than capital lease as here lessee has the option to replace or update their equipment as required.
- There is ownership transfer, hence, no risk of obsolescence
- Lease payments are tax-deductible and accounting for an operating lease is way straightforward.
Comparison between a capital lease and an operating lease
The total charges to operations are same over lease term in both the cases. However, in capital lease agreement, the charges are higher in the earlier years and lower in the later years. Further, if accelerated method of depreciation is used, the difference of amounts would be larger in earlier and later years.
The lessee shall not report under the operating method. The following difference does occur if the lessee uses the capital lease method instead of operating lease.
- There is a regular increase in the amount of reported debt i.e. both short-term and long-term.
- There is an increase in the amount of total assets.
- Further, lower-income is the result of the early life of the lease and hence, lower retained earnings in the earlier years.