capital lease vs. operating lease?

The other day a client of mine was asked if they had any capital leases and how they had accounted for it on the balance sheet, with supporting schedules.  This is a classic auditor question and led to a conversation around:

what is the difference between a capital lease and an operating lease?

Well, the Government of Canada has a nice concise definition to help us out:

• A capital lease is usually used to finance equipment for the major part of its useful life, and there is a reasonable assurance that the lessee will obtain ownership of the equipment by the end of the lease term.
• An operating lease usually finances equipment for less than its useful life, and at the end of the lease term the lessee can return the equipment to the lessor without further obligation.

A lease contract is an agreement under which the owner of the equipment (the “lessor”) conveys to the user (the “lessee”) the right to use the equipment in return for a number of specified payments over an agreed period of time.  Typical examples in the technology industry for capital leases are leased photocopy machines (e.g. Xerox) or servers (e.g. Dell).

what is the difference in the accounting treatment of these leases?

From an accounting point of view, leases which transfer substantially all of the benefits and risks incidental to the ownership of the asset are accounted for as if there was an acquisition of an asset and incurrence of an obligation at the inception of the lease (capital lease).  In this case the item is set up as an asset on the balance sheet and is depreciated over time; as well as the liability component (the capital lease obligation).  All other leases are accounted for as operating leases wherein rental payments are expensed as incurred (operating lease).

uhm, could you be a bit more specific on how to determine if it is a capital lease?

The typical guidance used to determine if a lease should be categorized, for accounting purposes, as a capital lease is when one or more of the following criteria are met:

• the lease term is greater than 75% of the property’s estimated economic life;
• the lease contains an option to purchase the property for less than fair market value;
• ownership of the property is transferred to the lessee at the end of the lease term;
• or the present value of the lease payments exceeds 90% of the fair market value of the property.

My client did have capital leases so they provided the auditor with: the journal entry to set up the asset and the subsequent monthly treatments, the lease payment schedule that included the ending value each month which ties to your capital lease obligation amount on the balance sheet, and the overall commitment schedule that matched their note disclosure.

wow, that is a lot of information … do you have an example?

Fortunately, Business Ready has created a Capital Lease template for a small technology company with a leased photocopier and servers.  It takes some effort to initially set the information up but, once done, the time saved during month end close and year end audit is invaluable.

Your auditors will also be looking for a formal policy on how you account for leases at your copmany.  Check out the Business Ready policy for Leases for which the Capital Lease template is meant to be a supporting document.