Types Of Lease

In general, operating leases “allow for both finance and upkeep” (Brigham & Ehrhardt, 2017, p. 792). Hence, the lessor, who owns the leased equipment, is responsible for ensuring that it receives regular maintenance and is kept in excellent working order. To offset these costs, the lessor frequently includes the cost of equipment maintenance in the lease. Moreover, operating leases aren’t fully amortized. The leased asset is unlikely to fully recoup its cost throughout its lease period. Extending the lease or leasing the asset to someone else makes it more likely to recover the whole amount. Finally, cancellation clauses are frequently included in operating leases so the lessee can end the agreement early if necessary.

A capital lease is a rental agreement for commercial property that is recorded as an asset on the balance sheet of the leasing company (Murray, 2019, Para. 4). maintenance is not included in capital leases and is fully amortized (Brigham & Ehrhardt, 2017). Equipment is recognized as an asset by the business and can be depreciated when it is leased on a long-term basis. When a capital lease is paid off, it frequently includes a provision transferring ownership to the lessee. Alternatively, there may be an opportunity to buy the equipment at the end of the lease at a discounted price, sometimes $1.

Capital leases are viewed as assets, whereas operating leases are viewed as expenses. Operating leases are not eligible for depreciation, whereas capital leases occasionally are. Depending on your situation, either capital or operating may be the best choice. A capital lease is preferable if you’re seeking a long-term asset. The asset may be depreciated, which lowers taxable income. The lease’s interest expense would likewise lower taxable income. At the end of the lease, the item can be acquired for a low price after being used for a considerable time. An operating lease is preferable if you’re looking for a short-term asset. In this manner, you avoid hanging onto a piece of property that can become outdated, and the lease payments are tax deductible.

References

Brigham, E. F., & Ehrhardt, M. C. (2017). Financial management: Theory and practice [with MindTap] (15th ed.). Mason, OH: South-Western.

Murray, J. (2019, Feb 22). Difference between a capital lease and an operating lease – Options for leasing business equipment. The Balance Small Business. Retrieved from https://www.thebalancesmb.com/capital-leases-versus-operating-leases-398034

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Compare two types of leases, and describe the advantages and disadvantages of each. Which type of lease would produce the lowest risk?

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