Operating Leases Versus Capital Leases

There are 2 kinds of leases: Operating and Capital. Do the differences really matter to a company choosing to lease equipment (the lessee)?? Yes they do.

Operating leases are considered the more favorable of the two. An operating lease is defined as paying for the use of the equipment only. This means none of the costs or obligations or tax treatment of ownership applies to an operating lease. The lease is treated as an operating expense in the income statement and has no affect on the balance sheet. Its true 'off balance sheet' financing. This is favorable as most firms prefer to keep leases off the books so as to allow them to try to get conventional financing more easily the next time around.

In a capital lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits. Consequently, the lease, when signed, is recognized both as an asset and as a liability (for the lease payments) on the balance sheet. The firm gets to claim depreciation each year on the asset and also deducts the interest expense component of the lease payment each year. In general, capital leases recognize expenses sooner than equivalent operating leases. There is an advantage and a disadvantage to this. If the firm (the lessee) is having a good year this year, then it's an advantage to recognize the expense sooner. However, if the business grows over the next few years as the firm hopes and expects it will, then it becomes more and more of a disadvantage. The operating lease has the same tax deductibility every year and it's every dollar of every lease payment tracked as an expense.

Thats the accounting and tax part. Now we have the real world differences. Primarily, the difference is in the residual value and buyout potential at the end of the lease. If a lease is structured with a $1 buyout at the end of the period, then automatically, we have a capital lease. The other two most common residual value buyouts of 10% and Fair Market Value can be either but usually lean towards operating leases for the tax reasons stated above.