Capital Lease vs Operating Lease | Effect on Lessor and Lessee

Capital Lease vs Operating Lease – Lease is a Contractual agreement between the lessor (owner of asset) and the lessee (rents the asset). There are classified into two types (Operating lease and Capital lease) depending on how the risk of ownership and benefits are transferred,

In this article, we look at Operating Lease and Capital Lease in detail and its key differences.

What is Lease?


Lease is an arrangement whereby the lessor conveys to lessee in return for a payment or series of payments the right to use an asset for a agreed period of a time.

capital lease and operating lease

In an agreement of lease the lessor and the lessee enter into an arrangement in which lessor transfer right to use an asset to lessee against a payment of lease rental for a period of time. In some cases if mentioned in the agreement or according to term and conditions of the lease , lessee has right to acquired ownership of the asset leased at the end of lease period.

 

 

 

 

Before we proceed you should know the difference between revise the meaning of Lessor and Lessee.

  • Lessee: Transportation (Trucks, Aircrafts), Real Estate (Building), Construction Agriculture
  • Lessors: Captive Leasing companies, Banks and other Independents

There are two types of leases viz Operating Lease and Capital Lease or financial lease. we will now look at them in detail.

What is Operating Lease?


Operating lease is stated as a lease agreement which does not involve transfer of substantial risk and rewards of ownership of the asset leased to the lessee. Operating leases generally have a period which is significantly less than the fair value of the asset leased.

Leases that do not meet any of the four criteria are accounted for an Operating Lease

  • Test1: Transfer of ownership (if yes, then Capital Lease)
  • Test 2: Bargain purchase  option? (if yes, then Capital Lease)
  • Test 3: Lease term > = 75% of economic life ? (if yes, then Capital Lease)
  • Test 4: Present value of payments  >= 90% Fair Market Value? (if yes, then Capital Lease)

Accounting treatment of Operating lease


 In the books of lessee

The operating lease does not result in recognition of an assets and liabilities on the balance sheet of a lessee. Lease payments other than costs of services like insurance, etc., should be recognized as an expense on straight-line basis, in the profit and loss account. However, if there is some other basis which is more representative of the time pattern of the user’s benefit then lease payments should be recognized using that basis.

In the books of lessor

In the books of lessor , an operating lease should be accounted for in the following manner :

  • The transaction is not a transaction of sale, hence, no selling profit is to be recognized.
  • Asset given under operating lease is to be shown in the balance sheet under “Fixed Assets”.
  • Costs, including depreciation, are recognized as an expenses i.e., depreciation is to be charged in accordance with the normal depreciation policy of the lessor.
  • Lease income other than receipt of services, e.g., maintenance, insurance, etc., from the operating lease is to be recognized in the profit and loss account on a straight line basis over the lease term. However, if there is some other basis which is more representative of the leased asset are diminished then, lease income should be recognized using that basis.
  • Initial direct costs incurred specifically to earn revenues from an operating lease may be dealt with in the following ways:
  • By allocation over the lease term in proportion to the recognition of rent income, or
  • By treating them as expenses of the period in which they are incurred i.e., by taking them to the profit and loss account of the year.

Examples of Operating Lease


Operating Lease Example 1

A company is about to enter into a three year lease to rent building. The lease cannot be cancelled and there is no certainty of renewal. The landlord retains responsibility for maintaining the premises in good repair, technically this lease is classified as operating lease.

Operating Lease Example 2

XYZ Limited obtained some special computer equipment from ABC limited on a 2 year lease which involves payment of $ 20,000 at the end of the first year and $ 25,000 at the end of the second year. Whereas the fair value of the equipment is $ 50,000 and the present value of minimum lease payments is $ 40,000. The lessee shall return the equipment to the lessor at the end of lease term and there is no option for the lessee to either purchase the asset at a lower price or extend the lease term. The useful life of the equipment is 5 years.

Answer to the above example.

The lease should be treated as an operating lease due to the following reasons:

  • The lease term is 2 years which is lower than the total useful life of the assets i.e. 5 years.
  • It does not involve transfer of ownership to lessee at the end of the lease period or term.
  • The present value of lease payment is fourth-fifth i.e. 80 % of the fair value of the asset which doesn’t fulfill the threshold limit of 90 %.
  • There is no availability of purchasing or buying option i.e., option to buy the asset at lower value at the end of lease term.

Accounting Entries for Operating Lease


As XYZ LIMIETD PAYS $ 20,000 and $ 25,000 at the end of second year, it has to recognize the expenditure of lease rentals over the term of lease using in way of uniform basis. The same process applicable to lessor also. The following are the journal entries in the books of lessee and lessor respectively

In the books of lessee

No journal entry at the time of beginning of lease.

At the end of first year

(Amount in $)

Particulars Debit Credit
Expenditure from Lease rentals (20,000/2 +25,000/2) 22,500 0
Bank 0 20,000
Accrued lease rentals 0 2,500
At the end of second year

(Amount in $)

Particulars Debit Credit
Expenditure from Lease rentals 22,500 0
Accrued lease rentals 2,500 0
Bank 0 25,000

In the books of lessor

The accounting entries in books of lessor are just the reversal of entries in books of lessee, which are mentioned below.

No journal entries at the time of beginning of lease.

At the end of first year

(Amount in $)

Particulars Debit Credit
Bank 20,000 0
Lease rentals receivable 2,500 0
Income from Lease rentals(20,000/2 + 25,000/2) 0 22,500
At the end of second year

(Amount in $)

Particulars Debit Credit
Bank 25,000 0
Lease rentals receivable 0 2,500
Lease rentals income 0 22,500

Recognition of Operating Lease

  • Lease rentals should be accounted for on accrual basis over the lease term so as to recognize an appropriate charge in respect in the profit and loss account with a separate disclosure thereof.
  • Or it may be say that aggregate of lease rentals payable over the lease term should, unless another systematic basis is more representative of the time pattern, be spread over the term on straight line basis, irrespective of the payment schedule as per the terms and conditions of lease.
  • The excess of lease rentals paid over the amount accrued in respect thereof should be treated as prepaid lease rental and vice versa.

What is Capital Lease?


It is also called financial Lease. A capital lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. In other words capital lease can be lease under which the present value of the minimum lease payments at the inception of the lease exceeds or is equal to substantially the whole of the fair value of the leased asset. A capital lease is a lease in which the lessee records the underlying asset as though its own asset, which means that the lessor is treated as a party that happens to be financing an asset that the lessee owns.

The lessor should treat a lease as a capital or financial lease if any of the following criteria provided below are met:

  • There is option to buy the leased asset; or
  • Lease period covers at least seventy five percent of the useful life of the asset; or
  • Ownership of the leased asset shifts to the lessee following the lease expiration; or
  • The minimum present value of the lease payments total at least ninety percent of the fair value of the asset at the starting of the lease.

Accounting treatment of Capital lease


In the books of lessee

  • Recognize the lease as an asset and a liability, at the inception of the lease. The lease should be recorded at fair value of the leased asset at the inception of lease, not exceeding present value of minimum lease payments from lessee’s perspective. Present value of the minimum lease payment is to be calculated using IRR (Internal rate of return).
  • Apportionment of lease payment – Just like in case of loan repayment, the installment amount is apportioned between interests and principal payments, in case of lease, payments are to be apportioned between the finance charge and the reduction of outstanding liability. Finance charge is to be calculated in a manner so that the rate of interest remains constant from one period to another. Thus, the reduction in the liability will keep on charging from one period to another. To be more specific finance charge will be higher and reduction in the liability will be lower in the initials periods as the absolute outstanding liability is more in the initials periods.
  • Depreciation on leased asset – Depreciation is to be calculated in respect of leased assets on a systematic basis for each accounting period. If there is a reasonable certainty that the ownership will vest with the lessee at the end of the term then depreciation is to be calculated on the basis of useful life of the asset else on the basis of shorter of useful life and lease term.

In the books of lessor

In the books of lessor, capital lease should be accounted for in the following manner:

  • In balance sheet, the leased assets are to be recognized as a receivable at an amount equal to the net investment in the lease.
  • Lease payments relating to the accounting period (other than costs of services) are reduced both from the principal and the financial unearned income.
  • Finance income is allocated over the lease term in a manner that return on net investment outstanding for various periods is constant.
  • Initial direct costs like legal fees, commission, etc., incurred by lessor can be dealt in two different ways i.e., either immediately recognized in profit and loss account or to be allocated against the finance income over the lease term.
  • Unguaranteed residual values are reviewed regularly.

Example of Capital lease


ABC Limited is a rail company which has been leased out generators from DEF Limited to provide backup to the transportation system during power outages. The lease period is a 6 year term in which ABC Limited has to $ 4 lakhs payment to DEF Limited at the end of each year. Rate of interest implicit in the lease is 10 percent. Present Value factor for 6 years at the rate of 10 % is 4.355.

Answer to the above example

Present value minimum lease payment = $ 4, 00,000 * 4.355 = $ 17, 42,000.

Accounting entries for Capital Lease


In the books of lessee:

A capital lease results in recognition of both asset and liability in the books of the lessee at the inception of the lease amount equal to present value of minimum lease payments.

Particulars Debit Credit
Lease asset $ 17,42,000 0
Leased liability 0 $ 17,42,000
At the end of first annual payment lessee record accounting entry mentioned below:

(Amount in $)

Particulars Debit Credit
Lease liability 3,60,000 0
Interest expenditure ($ 4,00,000 * 10/100) 40,000 0
Cash 0 4,00,000
At the end of first year

At the end of first year, the lessee shall made one extra entry to recognize the depreciation on leased asset. It depreciates at straight line basis on leased asset if it is an owned asset.

Particulars Debit Credit
Depreciation xxx 0
Accumulated depreciation 0 xxx

In the books of lessor:

The lessor shall record the start of a lease by creating the receivable amount of lease at its net investment in lease, which is equal to the minimum lease payments discounted at the rate of interest provided.

(Amount in $)

Particulars Debit Credit
Lease receivable 17,42,000 0
Asset 0 17,42,000
At the time of first payments

At the time of first payments, lessor shall record cash receipt, reduction in lease receivable and recognition of finance income.

(Amount in $)

Particulars Debit Credit
Cash 4,00,000 0
Lease receivable (4,00,000 – 40,000) 0 3,60,000
Financial income (4, 00,000 * 10 %) 0 40,000

The reduction in lease receivable minimize the principal balance is lease receivable to $ 13, 82,000 (17, 42,000 – 3, 60,000), which shall be reduce the next year financial income.

Capital Lease vs Operating Lease : Analyst’s Perpective


Example : Lessee’s Perspective: Classification of Leases

An equipment with a market price of (FMV) of US$100,000 and useful life of 5 years is leased to a lessee for a period of 4 years. The lease payments are US$26,000 a year. The borrowing rate for the firm is 8%, and the rate implicit in the lease is 7%. There is no provision for Lessee to purchase asset at the end of the lease term, nor any bargain purchase option.

capital-lease-vs-operating-lease-example

Let us first look at whether this is a capital lease or an Operating Lease. For this we perform the tests to determine the same.

capital-lease-vs-operating-lease-test-1-and-2

Test 1 and Test 2 results in Operating Lease.

capital-lease-vs-operating-lease-test-3

Test 3 implies it is Capital Lease.

capital-lease-vs-operating-lease-test-4

Test 4 implies this is an Operating Lease.

Overall, we know that if ANY of the test is not met, then the lease is classified as Capital Lease.

Analyst’s Perspective: Operating Lease Accounting


Balance Sheet Impact

There is no impact on the Balance Sheet of Lessee lessee-perspective-balance-sheet-impact-of-operating-lease

Effect on Income Statement

Lease payments will be treated as Expense in the Income Statement.

Effect on Cash Flows

  • Total lease payment reduces cash flow from operations
  • Operating leases do not affect the lessee’s liabilities and hence, are referred to as off-balance sheet financing
  • Footnote disclosure of lease payment for each of the next five years is required

Given this, if we assume in the above example that lease is an Operating Lease, then

  • Balance Sheet – No Impact
  • Income Statement Effect: Lease payments of $26,000 treated as expense
  • Cash Flow: Lease payment of $26,000 treated as outflow for Cash flow from operations

Analyst’s Perspective: Capital Lease Accounting


Below is the impact of Capital Leases on the Lessee Account.

Effect on Balance Sheet

lessee-perspective-balance-sheet-impact-of-capital-lease

Effect on Income Statement

Interest expense = Discount rate times the Lease liability at the beginning of the period

Depreciation Period calculations

  • If lease transfers ownership, depreciate asset over the economic life of the asset.
  • If lease does not transfer ownership, depreciate over the term of the lease.

Effect on Cash Flows

  • Only portion of the lease payment that is considered interest payment reduces CFO
  • Part of the lease payment considered payment on principal reduces CFF.

Capital Lease vs Operating Lease Example


We will use the same example for the comparison

An equipment with a market price of (FMV) of US$100,000 and useful life of 5 years is leased to a lessee for a period of 4 years. The lease payments are US$26,000 a year. The borrowing rate for the firm is 8%, and the rate implicit in the lease is 7%. There is no provision for Lessee to purchase asset at the end of the lease term, nor any bargain purchase option.

Balance Sheet Effect – Capital lease vs Operating Lease.

  • In the Operating Lease, there is NO balance sheet impact.
  • Balance Sheet impact comes only in the Capital Lease.
  • Present value at 7% is $88,067
  • Both Asset and Liability increases by the present value of lease payments at inception

capital-lease-part-1

Balance Sheet Effect as the payments are made are as per below

capital-lease-balance-sheet-impact-part-2

Book Value of Assets at the end of each year.

capital-lease-balance-sheet-impact-part-3

Please note that the following –

  • Depreciation (term of 4 years) = $88,067/4 = $22,017,
  • Principal repayments equals the lease payments LESS interest expense
  • The asset is being depreciated at a rate that is different from the rate of amortization for the liability, the two values are equal only at the inception and termination of the lease

Income Statement Effect – Capital vs Operating Lease

capital-lease-income-statement-impact-part-4

  • Operating income is higher for capital lease (This is because depreciation expense for capital lease is lower than the lease payments)
  • Net income is lower in early years for capital lease

capital-lease-income-statement-impact-part-5a

Cash Flow Effect – Operating Lease vs Capital lease.

capital-lease-cash-flow-impact-part-6a

  • In operating lease, the total cash payment reduces cash flow from operations.
  • In capital lease, the part of lease payment considered payment on principal reduces cash flow from financing activities
  • Total CF is unaffected by the accounting treatment

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