The two methods of accounting for leases include capital and operating leases. Normally, leasing equipment acts as an alternative to purchasing. Operating leases and capital leases are used for different reasons and outcomes and are treated differently on the business accounting books. Leasing traditionally is not the same as buying. When one buys a business asset such as vehicle or equipment, it is considered an asset. When one leases an item, one is paid for the use of the item but does not get permanent ownership of the item.
A capital lease involves leasing equipment that amounts to ownership and which gets to be reflected on the balance sheet of a company as an asset. From the position of the one leasing an item, a capital lease is like a purchase. From the position of one receiving the item, the lease is seen as a loan (Ambrose, Emmerling, Huang & Yildirim, 2018). Capital leases majorly apply on items that are not technologically obsolete. Capital leases grants the one leasing an item an advantage of owning the item.
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Operating leases are majorly used for short-term purposes and for equipment which are high techs such as office equipment and computers. The price of the operating lease is taken as the expensive for service or item use. The one leasing the equipment uses it but does not assume the drawbacks or benefits of ownership (Altamuro, Johnston, Pandit & Zhang, 2014). If one leases high technology equipment, one would have an operating lease. For instance, if one leases copies for the office, one should have an operating lease. However, if one leases a machine that one wants to use for a longer period, one should think of having a capital lease. For those interested in leasing cars, businesses prefer using operating leases since property like cars are used frequently used before turning them into models after the leasing period is collapsed. It is important to note that operating lease does not give one the ability to make the asset depreciate.
Because of the different methods used for the two different types of leases, the difference between the two is evident. First, a capital lease leads to a fixed asset getting recorded the balance sheet. This is opposed to operating lease which does not need a recording of an asset in the balance sheet. A capital lease leads to depreciation expense getting charged on the income statement (Ambrose, Emmerling, Huang & Yildirim, 2018). This is opposed to operating lease which doesn't have any depreciation charged on the income statement. A capital lease leads to a liability on the existing value of the total lease payments getting recorded on the balance sheet. This is opposed to operating lease which does not have any liability except for the existing lease payment.
The operating leases give flexibility which is much needed to the companies which often replace or update their equipment. Operating leases also protects the lessee from the problem of obsolescence. Operating leasing makes accounting simpler since it is not a must for the equipment on lease to be put on the balance sheet (Altamuro, Johnston, Pandit & Zhang, 2014). This is similar to the debt liability. Operating leases are tax deductible and they also provide an advanced return on an asset without restraints on capital budgeting. Capital leasing, on the other hand, acknowledges the expenses as sooner compared to operating leases. The depreciation of the item on lease is taken as a point of consideration by the lessee.
References
Altamuro, J., Johnston, R., Pandit, S., & Zhang, H. (2014).Operating leases and credit assessments. Contemporary Accounting Research , 31 (2), 551-580.
Ambrose, B. W., Emmerling, T., Huang, H. H., &Yildirim, Y. (2018). Capital Structure and the Substitutability versus Complementarity Nature of Leases and Debt. Review of Finance , 1 , 37.
