When a tenant, or "lessee," signs a lease, the lessee must then classify the lease as either a capital lease or an operating lease in its financial reports. The classification of the lease is determined by specific elements of the lease's terms. Lessees typically seek to classify their leases as operating leases because of the less-restrictive requirements in their financial reports, but occasionally capitalize the lease for certain circumstances.
Classification of the Lease
The Financial Accounting Standards Board specifies the way any lease is treated from an accounting perspective. FAS-13 is the specific regulation related to leases, and it outlines the four tests that govern classification. The qualifying tests look for features in the lease such as the automatic transfer of ownership to the lessee at the end of the lease term, or an option enabling the lessee to buy the property at the end of the lease term at a very low price.
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Disadvantage of a Capital Lease
If a lease meets one of the four tests and qualifies as a capital lease, the lessee calculates the present value of future payments in the lease and reports that value as both an asset and liability on its balance sheet. The lessee's net worth is not impacted because the equal values offset each other, but the presence of an additional liability on the balance sheet causes the lessee's debt-to-equity ratio to increase. This negative change in the ratio may appear troublesome in the eyes of an investor or regulator. By comparison, an operating lease is only summarized briefly in the footnotes of the financial reports and does not appear on the balance sheet where it can be used in calculating performance metrics.
Advantage of a Capital Lease
Many lessees avoid capital leases because of their balance sheet impact. When a company purchases a property, though, the acquisition cost of the property becomes an asset and any mortgage becomes a liability. A capital lease mimics a purchase because it effectively captures the ownership of the property but employs 100 percnent financing. Despite the impact on the balance sheet, this option conserves cash up front and is the primary benefit of a capital lease.
Comparison to an Operating Lease
Lessees use the accounting treatment of capital leases and operating leases to influence their decision-making. There is a long-standing debate about whether operating leases also should be reported on the balance sheet so they can be appropriately scrutinized as financial obligations. Because capital leases are already fully reported, they eliminate this concern.