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 off of another party. In a lease, however, the company will pay the other party an agreed upon sum of money, not unlike rent, in exchange for the ability to use the asset.
The company purchasing the right to use the asset is known as the lessee. The party offering the asset for lease, and consequently receiving the lease payments, is known as the lessor. Leases generate an interest expense in certain situations.
There are two types of lease classifications: 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 can occur when certain criteria are met. A capital lease can be assumed if:
- The lease duration is 75% or more of 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 allows 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 in a capital lease will record the asset and the corresponding lease liability in its balance sheet. The asset will be classified as plant, property and equipment while the lease liability is classified as a form of debt.
The lessee will also depreciate the asset over time, simply to the salvage value of the asset. If the lessee and lessor have agreed on a guaranteed residual value, which is a contractual agreement to return the asset at a certain market 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 containing financial statement.
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 the operating lease. In contrast, a capital lease may make a company more debt-heavy, thereby impacting its debt capacity.
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