Article: Leasing Capital Assets

Leasing capital assets

If you want to enjoy the benefits of ownership of leased property, the lease must meet certain criteria

Because it allows businesses to conserve capital and achieve certain tax benefits, the leasing of equipment continues to be a popular way of acquiring business property for companies of all sizes.

Lease terms and provisions can vary widely and are limited only by the ingenuity of the lessor or lessee and the peculiarities of the property. Those provisions affect a lease’s accounting and tax treatment, so it’s wise to learn a few rules before you commit to a major lease transaction.

There are two basic kinds of leases: an operating lease, which is like a rental agreement, under which the benefit and risks of ownership stay with the lessor (i.e., not you); and a capital lease, which is like an installment purchase, under which you take on the benefits and risks of ownership.

Capital lease. A capital lease must meet at least one of four criteria.

You (the lessee) take ownership of the leased property by the time the lease terminates.
The lease contains a bargain purchase option. This provision allows you to purchase the property for a price that is significantly lower than its expected fair market value, so that your exercising of that option is reasonably assured. For example, an option to purchase the property for a dollar at the end of the lease would qualify.
The lease term is equal to 75% or more of the estimated economic life of the leased property.
The present value of the minimum lease payments is equal to or more than 90% of the fair market value of the property.

If a lease meets none of these four criteria, it will be treated as an operating lease. The leased property does not appear as an asset on the balance sheet, and the lease payments are treated as rental expenses.

Accounting treatment. For accounting purposes, a capital lease is treated roughly the same as a situation in which the purchase of property and the related financing transaction occur separately:

The property is recorded as an asset and then depreciated.
The lease obligation is shown as a liability.
The lease payments are treated as amortized loan payments, with a portion expensed as interest and the remainder applied to the unpaid principal balance.

Look before you leap. Leasing can be a cost-effective way to acquire capital assets, but only if it is done correctly. Some lease provisions can result in exceptions or variations to the accounting treatments described above.

Before you enter into a lease that contains non-standard or exotic provisions, or if you’re unsure about how to account for a potential lease or about its overall economic benefits vis-à-vis an outright purchase, it will probably be worthwhile to consult your CPA.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.