When an organization wants to purchase assets they sometimes choose to lease assets rather than buy them out right. This type of financing offers many advantages to an organization, but they should keep in mind how the proposed lease will affect their overall financial position. The two kinds of leases that an organization can choose from is an operating lease or a capital lease. Both of these leases will in effect provide financing in order to acquire an asset, but the effects of each are accounted for differently and are reflected differently in organization’s financial statements.
An operating lease is the straightest forward of the two. The lessee (the organization) makes an agreement with the lessor (seller of the asset) for the use of an asset. Basically the organization is renting the asset with an installment payment (which usually includes interest) with intentions to return the asset when the lease ends. An example of an asset that would be commonly financed with an operating lease is new technology. Because technology is going to change, it is often better to lease the asset rather than commit large sums of an origination’s capital to an asset that is going to need to be upgraded every couple of years. The accounting for operating leases is quite simple. Because an organization does not own the asset, it is not recorded on the firm’s balance sheet. The only effect that an operating lease has on organization’s financial statements is the lease payments will appear as an operating expense on the entity’s income statement. Since an operating lease is not recorded on the balance sheet, it is sometimes referred to as off balance sheet financing. The main advantage of an operating lease is that the organization can use the asset without the usual attributes of ownership (i.e. the liability that would come with financing an asset and the depreciation expense that would come with an owned asset). Another advantage of an operating lease is that since it is not treated as a liability the organization will maintain their current access to capital. That is because the lease payments are not treated as debt and this helps the organization to maintain their current debt capacity. Thus the organization is able to use the asset to produce revenue, and is able to maintain its current access to the capital markets through debt. Continue reading ‘Operating Vs Capital Leases (What’s the Difference)’ »