Not having tons of cash is not something that can deprive you of starting and running your startup smoothly. The lack of cash for buying equipment is replaced with the option of a lease. Besides, for getting an asset the pain of purchasing and looking for the right asset is also not the burden of the end-user. Despite all the ease, there is still a need for finding the right lease option for your needs. If you are thinking of getting a piece of equipment for your work on a lease you might be wondering about operating lease and capital lease options. We are here to help you with your quest for the lease option suited to your needs.
So use the cost-effective option of a lease without having to purchase the asset then and there. Not knowing the difference between the types of a lease may leave you in tears later, if not in the beginning! Alright, jokes apart, you are going to cry selecting the wrong type of lease but you might not attain full advantage and we do not want that. So let us get started summarizing the knowledge of Accounting Standards for you.
Capital lease is the lease agreement where the asset appears in your books of accounts specifically in your statement of financial position as an asset. Alright! We must not be using the jargon here, so let us get that straight and simple. In a capital lease, the ownership of the asset is yours. Here you own the asset and pay a fixed amount over the said period.
Businesses usually opt for capital lease for the assets with a generally long-term life span. This means those assets that are of use even after the period of lease is over or the asset does not get obsolete in terms of operation and technology. Here, with the capital lease, the risk and reward of the ownership lie with you. That means you are the one responsible for any damage caused to the asset or benefit that the asset provides.
Operating lease is where the ownership of the asset remains with the lessor. That means the risk and reward to the asset remains with the lessor as him being the owner. The agreed amount paid over the period of time is counted as a rental expense of using that asset. You may not prefer acquiring a piece of equipment on capital lease with a short period of time or an asset that may g obsolete after the term of the lease.
Following are the question you can directly address to understand whether a lease is a capital lease or an operating lease:
Who is going to be the owner of the leased asset after the expiration of the leased term?
So whether are you going to be the owner of the asset after the expiration of the lease term or not is an important question. There are so many lease contracts that do not transfer the asset to the lessee. So if you are not getting the ownership even after the expiration of the lease term then the lease is an operating lease.
Do you have an option to buy the asset after the expiration of the lease term?
You might not just become the owner of the leased asset after the expiration of the lease term but you may have an option to purchase the asset on a price lower than the asset’s fair market value. If you have such an option then the lease is a capital lease and otherwise, it is an operating lease.
How much of the life span of the asset does the lease constitute?
When you buy an asset for your business, whether it be has a small asset or a huge one you must calculate its estimated life. It is necessary for the right accounting treatment of the purchase you made. If your lease term constitutes 75% or more of the life of the asset you purchased then it is a capital lease.
What is the proportion of the Present Value of the asset to its fair market value?
If the present value of your lease payments equals 90% or more than your lease is a capital lease otherwise it is an operating lease.
Fun Fact: Here it is worth noting that the capital lease concept, in the Accounting Standards with effect from 2019, has changed to the concept of finance lease.
Accounting Treatment: Even if you never studied accounting we have got the concept of accounting the leased asset really simple for you.
As the main concern here is the transfer of ownership to the property so for an operating lease you expense out the lease rental periodically.
Besides, on getting into a contract for lease you credit an amount of the total lease payment as payable that you debit an Operating Lease Right of Use with the same amount.
You debit the lease rentals and the payables and credit the Operating Lease right to Use and the Checking Account.
For a capital lease, as you get into a lease contract, you debit the purchase as a fixed asset in your books of account and credit the same value as the liability in your payables.
You debit depreciation expense and credit the accumulated depreciation to record the asset in your books on its present value.