Business is ultimately about money. Said Idowu Koyenikan, author and international consultant, “Money is always eager and ready to work for anyone who is ready to employ it.” As a smart small business owner, you want to use your scarce capital wisely to grow your business. Alfred Marshall, British Economist, said aptly, “Capital is that part of wealth which is devoted to obtaining further wealth.” So, when you approach major financing decisions, what’s your pick, capital vs operating lease?
What is a Capital Lease? An Operating Lease?
Leasing such things as building space, equipment, machinery or vehicles is a common and cost-effective alternative to purchasing them. There are two kinds of leases, capital, and operating leases, and each is used for different purposes. Each will be treated differently on the accounting statements of a business.
A Capital Lease
A capital lease is a lease of an item that represents ownership. At the end of the lease term, you will typically own the item. A capital lease:
- Is used for long-term purposes and for things that don’t become technologically obsolete.
- Gives the lessee business the benefits and drawbacks of ownership.
- Is considered a debt of the lessee.
An Operating Lease
Operating leases are sometimes referred to as service leases and are used for short-term leasing (a year or less in length) and are typically for items that are high-tech, or in which the technology changes. For example, computer and office equipment. The lessee uses the item but does not take ownership of the item.
Accounting for a capital vs operating lease is treated differently. A capital lease is treated as a loan; the asset is treated as being owned by the lessee, so it stays on the balance sheet and is depreciated in value over time. An operating lease is treated like renting—lease payments are considered operational expenses. Obviously, because of the different treatments, the lease can have a significant impact on the business’s taxes.
Your Best Option: Capital Lease vs Operating Lease
As you would expect, “it depends.”
The advantages of a capital lease are:
- The lessee is allowed to claim depreciation of the asset. That reduces taxable income.
- Interest expense on the lease also reduces taxable income.
- You can use the item for an extended amount of time and then purchase it for less than the current market value.
The advantages of an operating lease are:
- No risk of obsolescence, since there is no transfer of ownership.
- Lease payments are tax-deductible
- Flexibility is gained to replace or update the item more often.
- Accounting for an operating lease is simpler.
Seek Expert Financing Assistance in Managing Capital vs Operating Leases
Contact Doerhoff & Associates, CPA serving the greater Jefferson City, MO area for expert accounting and financial advice. We provide a comprehensive approach to business accounting services to save you time and headaches so you can focus on running the business you love.