It’s Almost Tax Day – What type of lease do you have?
With tax day quickly approaching, we’d like to address a greatly misunderstood area of corporate real estate leasing – capital leases versus operating leases.
In the accounting world, payments for leased corporate assets must be accounted for correctly, and the Financial Accounting Standards Board (FASB) has developed criteria to help you as a manager identify your type of lease. What it comes down to is whether the risks and benefits of ownership rest upon the owner or the lessee:
Capital Lease – Assets appear on statements as if they had been purchased, so the rental payments are treated as interest on a loan taken out to pay for them. The asset (and its accompanying liabilities) is capitalized either by recognizing the present value of the minimum lease payments or the value of the leased assets – whichever is lower. The leased asset is depreciated in the same way as if they had been purchased by the company while its associated liabilities decrease as the rent is paid.
Operating Lease – Payments are simply expensed as they are made because rent is treated as a straightforward expense. The leased asset itself (and associated liabilities) is not recognized.
Until the FASB established its legislation in the 1970s, leasing assets was a common way for companies to avoid declaring their obligations in financial reporting. They only had to disclose leases in statement footnotes, rather than record them as liabilities and so leasing assets was essentially a means of financing a company off the balance sheet. But that changed in 1976, when the FASB issued “Statement no. 13, Accounting for Leases,” which established four questions that would determine whether a lease should be defined as operating or capital:
1. Is ownership of the asset transferred to the lessee during the term of lease?
2. Can the lessee buy the asset at a nominal price – $1, for example – when the lease expires (the “bargain purchase option”)?
3. Will the asset be leased for at least 75 percent of its economic life?
4. Is the present value of the minimum lease payments at least 90 percent of the value of the asset?
If the answer to all these questions is “no,” then the agreement should be treated as an operating lease. If the answer to any of the questions is “yes,” it is regarded as a capital lease.
Questions? Feel free to contact Omni Realty Group, 717-657-5833, ext. 3 (office), 717-991-6384 (mobile) or email@example.com.