Operating Leases Become a Capital Issue

Does your organization lease property, plant & equipment? Odds would have it that many of you utilize leasing equipment. And Why not? Leases allow you to obtain assets while minimizing the affect on your cash flow, since most leases require a minimal, if any, initial investment. Also, we all know that everytime you blink technology advances, and leasing helps you keep up with that pace by allowing your assets to change as quickly as your business needs do.

But, one of the biggest advantages to leasing is about to have a major renovation.

Currently the U.S. accounting standards define two types of leases, operating and capital. The difference? Capital leases are included in the organization’s balances sheet, whereas operating leases only touch your income statements. See the advantage? You can keep major assets off your books and their long-term payment obligations as well.

Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), are teaming up and discussing the elimination of the operating lease. Under their proposed guidelines, essentially all leases, for all companies, will be treated as capital leases starting as early as 2011. To see reactions to this change you can read this article.

How does this affect your organization? It would require you to review all your current operating leases and reclassify them into capital leases. Variables such as, the size of your company, the amount and value of your leases, and lease terms will determine how large of a headache this will be.

How is a capital lease recorded? Basically, capital leases are treated as assets that are purchased over time with a note. At inception, the leased asset is booked at the lesser of its market value at inception or the present value of the minimum future lease payments with the offset booked to a capital lease liability. As lease payments are made they are treated similar to payments on notes: reduction of principal (capital lease liability), and interest expense.

The asset also has to be depreciated over its “period of benefit.” Period of benefit is determined as the term of the lease if you are not taking ownership of the asset once the lease ends. If you are taking ownership of the asset then you would use the “estimated economic life” and depreciate it in the same manner as your other purchased assets.

Have questions? Give me a call.

Rocky Miller, RCO Senior