CAPITAL VS OPERATING LEASES

Why do we ask our clients each year if they have entered into any new lease agreements?

We are required under generally accepted accounting principles (GAAP) and more specifically, Financial Accounting Standards 13 (FAS 13), to make sure a proper determination and adequate disclosure have been made regarding capital and operating leases. Based on a review and analysis of the lease agreements, we can make a determination (using FAS 13 guidelines) as to whether or not new leases are properly recorded as capital leases or operating leases. Generally, if a lease qualifies as a capital lease, an asset and a liability need to be recorded on the books. The capital lease assets are then also subject to depreciation. If a lease does not qualify as a capital lease, the only item recorded on the books is lease expense as the lease payments are made to the lessor.

Accounting for leases is based on the understanding that a lease which transfers substantially all the risks and rewards of ownership should be capitalized like any other owned fixed asset. Whether or not to record a lease as a capital lease or an operating lease is determined by meeting certain criteria. A lease is a capital lease if at the inception of the lease, one or more of the following criteria are met:

1. The lease transfers ownership of the property to the lessee by the end of the lease term. If at the end of the lease, the lessee owns the property, the lessee in effect has bought property that needs to be recorded on their books at the inception of the lease.

2. The lease contains a bargain purchase option. Often, a lease will include a provision that allows the lessee to purchase the property at the end of the lease for significantly less than the estimated fair market value. In general, it is assumed that most lessees will exercise this option.

3. The lease term is equal to 75% or more of the estimated economic life of the leased property. If you lease a piece of manufacturing equipment that historically needs to be replaced every six years, and the lease is for five years, the lease is capitalized as most of the risks and rewards of ownership have transferred to you.

4. The present value of the minimum lease payments equals or exceeds 90% of the fair market value of the leased property. If the present value of the minimum lease payments is reasonably close to the fair market value of the property at the inception of the lease, the property is effectively being purchased.

If a new lease does meet one of the above criteria, the lessee needs to determine the cost of the asset and the corresponding liability that will be recorded on the books. The first step is to calculate the present value of the minimum lease payments. The lessee computes the present value of the minimum lease payments using their current bank borrowing rate unless the lessee learns the implicit rate computed by the lessor and that rate is lower than the lessee's current bank borrowing rate. Once this is complete, the present value amount is compared with the current fair market value and the lower of the two is recorded as the asset and the liability. If the lease meets criteria number 1 or 2, the capital asset is depreciated over its useful life. If the lease meets criteria number 3 or 4, the capital asset is depreciated over the lease term. If the lease does not meet any of the above criteria, the lessee does not record anything on the balance sheet, but recognizes rent expense as the lease payments are made in most circumstances.

Prior to entering into any new leasing arrangement, you should analyze the effects of capital versus operating leases on your financial statements. We can assist you with the analysis and proper recording of the leasing transaction.

Mary F. Actor, CPA
Assurance Services Department