The beauty of leases lies in their mechanism.
A lease is an official, legally binding document that contains the rights of use of an asset. However, here's the catch: a lease lets the lessee use the asset without actually claiming ownership of it.
The ownership remains with the lessor who furnishes the lease and decides the terms and conditions contained in it.
This mechanism, especially for businesses, makes it simple to own and operate assets that come at high costs, for example, industrial equipment or land.
By leasing out an asset, a business can operate/use it for the term decided and then return it to the lessor. Leases also provide the flexibility of renewal if a beneficial relationship is established.
You can say that a lease is similar to a contract – the only difference being that leases involve assets, whereas contracts involve entities. On that note, businesses use multiple types of leases to make operations easier.
Through this blog, you will learn about capital lease vs. operating lease, and when you're done reading, you'll be able to decide which type of lease is better for acquiring or renting assets for your business.
A capital lease is a special type of lease that impacts the ledgers of your business.
In this lease, the lessor rents an asset to the lessee. The lessee then uses this asset like they own it. But even though the asset has only been leased and not sold, the accounting would treat the asset as “owned” in the lessee’s ledgers.
When the term of the capital lease ends, the lessee has two options:
With that said, for a lease to qualify as a capital lease, it should satisfy at least one of the following conditions:
For example, if a company capital leases a fleet of cars, the depreciation and maintenance costs for the lease term would be the responsibility of the lessee.
At the end of the term, the company can purchase the car for a discounted payment. This mechanism is beneficial for expense recording and taxation purposes in accounting.
An operating lease is a lease where there is no transfer of ownership. The lessee must return the leased asset to the lessor at the end of the term.
However, that does not make the lessee responsible for the maintenance and depreciation of the asset leased.
In simpler terms, an operating lease is where your business “rents” an asset to use for a specific period.
During this time, you are paying rent as agreed on the operating lease for using the asset. When the term ends, your business returns the asset to the owner.
Such leases are common in the construction industry because construction equipment is a costly purchase.
The depreciation and maintenance involved are also heavy expenses, which makes leasing the better option. Contractors lease out construction equipment on operating lease to builders for use for a specific term.
Capital leases convert into ownership of assets when the term expires for the lessee. This essentially means that for accounting and taxation purposes, this lease is treated as a purchase expense.
In terms of accounting, a capital lease shows up on the balance sheet as an owned asset. The value of this asset, for the company’s accounting and taxation systems, is determined by cost basis (the original cost of property).
One major accounting benefit that comes with capital leases is that they reduce the lease liability and entitle the business to deductions on expense over the interest on the rent.
For taxation purposes, a capital lease must satisfy all of the following conditions:
The beauty of an operating lease is that it treats the asset as a property that is merely being rented, with no ownership transfer in the picture.
This allows businesses to access costlier equipment or other assets for use without the burden of massive capital investment.
There may be clauses in an operating lease that require the lessee to maintain the asset in the condition as received when leased.
The accounting statements for operating leases do not show up on the balance sheet as expenses. Instead, you would spot these expenses on your company’s profit and loss sheets.
Much like your business records the interest payments made towards debts, the payments towards operating leases would be recorded similarly. The payment towards the lease would look like the operating expenses of your business.
Pro Tip: It is difficult to keep track of all your leases and the pertaining data manually. Instead, consider creating your own lease management software on no-code platforms like Hubler for streamlining leases.
Listed below are some of the key advantages of capital leases:
Operating leases are the most beneficial for assets or equipment that you don’t intend to use for the long term. Some other advantages of operating leases are mentioned below:
Operating leases and capital leases have different mechanisms of asset usage and rights. Each type of lease is suitable for different situations and for different kinds of assets.
A capital lease can be considered in cases where your business needs to acquire an asset and benefit from the expenses that it can reflect on the balance sheets. For example, leasing a piece of land for establishing a manufacturing unit.
On the other hand, an operating lease is the better option for assets that depreciate quickly and deliver little value when owned.
The kind of lease your business should opt for ultimately depends on the type of asset to be leased and the nature of the lease's benefits.
Capital leases and operating leases are both beneficial in their own place and right.
Whichever your business chooses, in the end, there would be the need to manage all its leases efficiently. It can be done using lease management software that you can either purchase or create by yourself.
LeasO is the perfect no-code platform that brings lease accounting, lease administration and lease management all under one easy-to-use interface.
To know more, book a demo with us.