While leasing may seem like a relatively straight forward process, the accounting and tax treatment of leases can vary greatly depending on if a lease is considered to be capital or operating in nature. This article will help you understand the differences and the implications of classifying your lease as a capital lease vs. an operating lease.

Capital Lease

A lease will be categorized as a capital lease if it meets any of the following conditions:

• There is a bargain purchase option, where the asset either automatically transfers to the lessee at the end of the lease term or can be bought for an amount that is less than what the asset would actually be worth.
• The term of the lease is more than 75% of the effective useful life of the asset.
• The present value of the lease payments exceeds 90% of the original cost of the asset.

When a lease is considered to be a capital lease it is treated as if the asset is acquired through a loan. The company will recognize the asset on their balance sheet and also recognize the lease obligation as a liability. Over time the asset will be amortized like any other capital asset and the lease obligation will go down as lease payments are made.

For tax purposes the company will also treat the lease in a similar fashion, with the asset being recognized and a depreciation expense recognized over its life. Some companies prefer to use capital leases as the accelerated depreciation allows them to expense the assets (for tax purposes) more quickly up front instead of evenly over the life of the lease. There are also interest expense components of the lease payments they will be able to separately expense.

Operating Lease

A lease that doesn't meet the criteria to be a capital lease will automatically be considered an operating lease. These leases have an accounting treatment similar to renting, where an expense is recognized as lease payments are made and not asset or liability is booked on the company's balance sheet.

For tax purposes the treatment is similar, with lease payments being deducted from taxable income and reducing the overall tax burden.Most leases qualify as operating leases due to their underlying terms. Some companies also prefer to use operating leases as the payments are fully expensed and the accounting implications are far simpler. The lessee is also protected from holding assets for long periods of time (as the leases are shorter and do not see the asset transferred when finished) and having obsolete assets. Many companies lease assets that require frequent replacement and become technologically obsolete in a short period of time.

Capital Lease vs. Operating Lease

Both leases offer benefits and advantages and depending on the nature of the assets a company can benefit from holding capital or operating leases. It's important to note, however, that operating leases may become extinct for accounting purposes as both the U.S. and International accounting regulators are looking to treat all leases as capital in nature.