What are Lease Classifications?
Lease classifications include operating leases and capital leases. A lease is a type of transaction undertaken by a company to have the right to use an asset. In a direct purchase, a company will simply purchase the asset from another party. In a lease, however, the company will pay the other party an agreed-upon sum of money for the use of the asset – similar to rent payments.
The company purchasing the right to use the asset is known as the lessee. The party offering the asset for lease and receiving the lease payments is known as the lessor. Leases generate an interest expense in certain situations.
There are two basic categories of lease classification: the operating lease and the capital, or finance, lease.
What is an Operating Lease?
In an operating lease, the lessee receives the right to use the asset but does not record the asset or the lease payment liability on its balance sheet. Thus, the operating lease is considered to be “off balance sheet financing”. Instead, the lessee will record lease payments as rental expense in its income statement, either under cost of goods sold or under SG&A.
What is a Capital or Finance Lease?
In a capital lease, the lessee receives the right to use the asset and substantially receives all the benefits and risks of owning that asset. This transfer of risk and benefits occurs when certain criteria are met. A lease is deemed a capital lease if the following criteria are met:
- The lease duration is 75% or more of the asset’s useful life
- The net present value (NPV) of lease payments is 90% or more of the asset’s fair value
- There is a direct term or clause in the lease stating transfer of title – or –
- There is a term in the lease that enables the lessee, at the end of the lease, to purchase the asset at a discounted price (also known as a bargain purchase option, or BPO).
As opposed to the operating lease, a lessee with a capital lease records the asset and the corresponding lease liability on its balance sheet. The asset will be classified as plant, property, and equipment. The lease liability is classified as a form of debt.
The capital lessee will also depreciate the asset over time. If the lessee and lessor have agreed on a guaranteed residual value, then the lessee will depreciate the asset over time to this residual value.
Any non-cash financing for this lease is disclosed in the footnotes of the company’s financial statements.
Significance of the Lease Classifications
Because of the nature of each lease classification, there can be an impact on profit and debt capacity. Since operating leases are “off balance sheet”, the company’s capital structure does not change due to an operating lease. In contrast, a capital lease may make a company more debt-heavy, thereby impacting its debt capacity.
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