Leasing is a cost-effective way to obtain an asset, such as a vehicle or piece of equipment, without purchasing the asset outright. It's important to know what type of lease you are entering and which option is the best for your business. There are two types of leases: operating leases and capital leases. Both options have their advantages and disadvantages, so read on for a detailed explanation to these 2 different types of leases and how the terms can effect your business.
What Is an Operating Lease?
An operating lease lets businesses finance equipment that quickly becomes outdated, like assets that are high-tech or in which technology changes. Operating leases also generally have lower monthly payments, since you're not financing the total cost of the asset, you're only renting it for a short time. The rental cost of an operating lease is considered an operating expense.
Operating leases do not transfer ownership of the asset when the contract ends. The lessor would have to offer the asset at its fair market value, unlike a capital lease.
What Is a Capital Lease?
There are 4 conditions that a lease must meet to qualify as a capital lease.
Ownership: The asset ownership is transferred to the lessee when the contract ends.
Purchase Option: The lessee can buy the asset at a discounted price when the lease ends.
Term: The lease has a term that is greater than the useful life of the asset.
Present Value: The present value of the lease payment is equal to the asset’s fair market value.
Capital leases count as debt and depreciate over time and incur interest expenses. The lessee essentially owns the asset, therefore being responsible for maintenance, etc. A capital lease works best for equipment with a long use life, such as construction machinery. The purchase options are excellent, generally $1) or 10% of the purchase price.
A $1 buyout option is best for businesses with sufficient cash flow, as the monthly lease payments are often higher across the life of the lease. Monthly lease payments are lower with the 10% buy option, but the lease will come with a larger payment at the end of the term.
Capital Lease vs Operating Lease Accounting
Capital leases are treated much like loans in a business's accounting. The asset is recorded on the business's balance sheet along with the liability for the payments. You can take capital lease tax deductions for depreciation expenses and interest.
Accounting for operating leases is usually easier, since most operating leases last 12 months or less and payments are recorded as operating expenses on your profit & loss statement.
The Bottom Line
Leasing can be a cost-effective way to acquire the assets you need to facilitate the growth of your business. Both capital and operating leases are usually more flexible than traditional loans. Capital leases are best for leasing assets for a long time and you are expected to purchase it. Operating leases are for short term commitments. Each lease comes with its own advantages, so consult with your accountant to find out which one is going to work best for your business.
Looking for equipment financing and leasing options? Check out Union Commercial Capital's funding solutions or fill out the apply now form to contact a representative.
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