How to Determine Finance Versus Operating Leases

Since the Financial Accounting Standards Board set a new standard for lease accounting, organizations may need to reassess their lease contracts.

When Accounting Standards Codification (ASC) 842 replaced the previous U.S. Generally Accepted Accounting Principles (GAAP) standard ASC 840, it closed a loophole that American companies had been using for years to keep their debt-to-equity ratios low.

ASC 842 mostly preserved the distinction between operating leases — which give the lessee the right to use the leased asset during the term of the lease — and finance leases (formerly known as capital leases) — which transfer ownership of the asset to the lessee at the end of the term.

Both types of leases, however, are now recorded on the balance sheet and there are differences in the accounting process for each.

Operating Leases

The U.S. GAAP treats operating leases like rental agreements, meaning lease payments are considered operating expenses. Assets being leased are not recorded on the company’s balance sheet, but are instead expensed on the income statement, affecting both operating and net income.

Operating leases are also characterized by:

• Being retained by the lessor during and after the lease term.
• An inability to contain a bargain purchase option.
• The term is less than 75% of the asset’s estimated economic life.
• The present value of lease payments is less than 90% of the asset’s fair market value.
• Having no ownership risk as payments are considered as operating expenses and are shown in the balance sheet’s profit and loss statement.
• The lessee is considered to be renting and the lease payment is treated as a rental expense.
• Risks/benefits remaining with the lessor and the lessee pays maintenance costs.

Operating leases provide greater flexibility to companies as they can replace or update their equipment more often and there is no risk of obsolescence, as there is no transfer of ownership. Accounting for an operating lease is also simpler and lease payments are tax-deductible.

Finance Leases

Finance leases are considered more like a long-term loan with the asset treated as though it is owned by the lessee and is recorded on the balance sheet. These leases are also counted as debt, depreciate over time, and incur interest expenses.

Finance leases also meet the following criteria:

• Ownership might transfer to the lessee at end of the lease term.
• Bargain purchase option enables the lessee to buy an asset at less than fair market value.
• The term equals or exceeds 75% of the asset’s estimated useful life.
• The present value of lease payments equals or exceeds 90% of the asset’s original cost.
• The lease is considered an asset (leased asset) and liability (lease payments). Payments are shown on the balance sheet.
• As the owner, the lessee claims depreciation expense and interest expense.
• Risks/benefits are transferred to the lessee, who pays maintenance, insurance, and taxes.

Advantages to a finance lease include the lessee being allowed to claim depreciation on the asset, which reduces taxable income. Interest expense also reduces taxable income.

In general, finance leases recognize expenses sooner than equivalent operating leases.

Keeping your business compliant

Depending on your company’s requirements and tax situation, you may opt for either a finance and operating lease, or even a combination of both for different types of assets.

While the requirements for the new lease standard may seem complicated or overwhelming at first, help is available to keep you and your business compliant.

If you have any questions about the information above, please contact your E. Cohen advisor.