A Leased Asset is an asset leased by the owner to another party in return of money or any other favor. While leasing an asset, the owner enters into a contract allowing the other party the temporary use of an asset.
Capital Lease and Operating Lease
In terms of accounting, one can lease an asset in two ways – Capital Lease and Operating Lease. The difference between the two is on the basis of whether or not the risk and reward with the asset are transferred to the lessor or not.
If the lessor gets the risks and rewards, it is a Capital lease or Financing lease under IFRS Standard. A lease qualifies as a capital lease if it meets any of the following conditions:
- Lease term must be greater than 75% of the asset’s useful life.
- There is an option for a lessee to acquire the asset at the end of the lease term at a price lower than the market value.
- Ownership transfers to the lessee after the end of the lease period.
- The present value of the lease payments is greater than 90% of the fair market value of the asset at the start of the lease.
All other types of the lease come under operating lease and are the same as a rent contract between a landlord and renter.
Accounting Treatment Of Leased Asset
Though a capital lease is a type of rental agreement, GAAP treats it as a purchase of assets if it meets certain conditions. Moreover, a capital lease affects the lessee’s financial statements, including interest expense, depreciation expense, assets, and liabilities.
A capital lease is a type of loan, and thus, the lease payment comes in the income statement. The lease payments also include interest, and the lessee needs to record it separately. For instance, if in a lease payment of $1000, $200 is for the interest expense, then $800 would be a debit to the capital lease liability account and $200 to the interest account. The accounts payable account gets a full credit of $100.
Lessee also needs to calculate the present value of all lease payments. This value is the recorded cost of the asset and must be debited to the appropriate fixed asset account and credited to the capital lease liability account. In the balance sheet, the present market value of the leased asset comes under the asset side.
Under a capital lease, the lessee must record the depreciation in a usual way. For instance, if an asset costs $100000, no salvage value, and has a useful life of ten years, then the annual depreciation on a Straight-line basis will be $10000.
If the leased asset is disposed of, the fixed asset account is credited, and the depreciation account is debited. This helps in eliminating the balances in these accounts. And, if there is a difference between the sale price and the net carrying amount of the asset, it is the profit or loss. This profit or loss from the disposal of the leased asset is recorded in the same period when the asset was disposed of.
An operating lease does not affect the balance sheet of a company. They are short-term leasing of an asset and are similar to any renting contract. The regular lease payments are operating expenses and thus, come under the income statement. Since the lessee does not get any ownership rights, the asset does not appear on the balance sheet. Thus, the lessee does not charge any depreciation.
Read a detailed article on Accounting of Capital And Operating Lease by Lessor and Lesses.
- In the case of an operating lease, the company creates an expense and not a liability. This helps it to keep its balance sheet clean. That is why an operating lease is “off-balance sheet financing.”
- Lessee faces no risk of obsolescence under operating lease as there is no transfer of ownership.
- Interest expense and depreciation lower taxable income for the lessee.
- Since cash outflow or lease payments are spread over several years, this lowers the burden of making one-time significant cash payments.
- If a business leases an asset instead purchasing it, this frees the capital for other investments.
- Lease expenses remain constant over the lease tenor or grow in line with the inflation. This helps a business to accurately plan cash outflows.
- Leasing is a good option for startups as it means lower capital requirements.
- A big disadvantage of leasing is that it may result in agency cost problems. Since the lessor transfers all rights to a lessee for a specific time, the lessee is free to use the asset the way they like, and this result in a moral hazard issue. As lessee is not the owner and thus, may not take enough care of the asset. This separation between the ownership and the control of the asset is known as the agency cost of leasing.
- Since the capital lease is a type of debt, it may limit a company’s borrowing ability.
- Lease payments lower the net income for the equity holders.