When business owners and financial managers enter into business equipment leases there needs to be an election, or ‘choice ‘ at the start of the transaction as to whether the company will reflect the lease on the company’s books as a capital lease , or an operating lease . What is the difference between these two leases, asks the business owner, as long as I have received equipment and financing approval ?
The answer is that the type of lease that the business has entered into has a direct impact on the company’s financial statements . Each lease has is own type of characteristics , and needs to be classified properly by your accountant .
Accounting standards have essentially established four criteria around how the business must treat the lease . Things are kept relatively simply, because in realty the tax department says that if your business equipment lease meets any one of the four criteria it is to be treated as an capital lease .
It goes without saying that lenders who specialize in operating leases make significant efforts to ensure their equipment leases do not pass any of the four criteria .
Lets looks at the 4 criteria . They are as follows :
1. TITLE TRANSFER
2. BARGAIN PURCHASE OPTION
3. LEASE TERM IS > or = 75% OF THE ASSETS ECONOMIC LIFE ( More about this one later!)
4. PRESENT VALUE OF MINIMUM LASE PAYMENTS ARE > or = FAIR MARKET VALUE
Title transfer is simply that, at the end of the lease the title of equipment, the ownership, reverts to the borrower , or lessee ,.
In he bargain purchase option scenario many leases are written so that at the end of the lease the customer has the right to purchase the asset for a specific amount. Many lessors simply use 1.00$ as the bargain purchase option amount, as they have essentially recovered all their capital and interest .
In category three if the lease term , or length of the lease, is equal to 75% of the life of the asset the transaction is viewed as a capital lease . This is certainly one of the grey areas of leasing, as we can all imagine as to who can really say what the useful economic life of any piece of machinery , etc, is? The whole point here is that if a lease has a short term then clearly it could be attacked as being a rental , with the owner having no intention to acquire the asset .
For our final category item, if the present value of the minimum lease payments is equal to or greater than 90% of the equipment value the government is essentially saying ? you own it ?! At this point the tax department is saying ? this is the same as if you were to buy the asset outright?.
In summary, if any of the four criteria are in place for any business equipment lease the lease is to be treated as a capital lease .
The accounting treatment is different for a capital lease, versus and operating lease , and that treatment will be explored outside of this article .