Balance Sheet Blues Part I: Operating vs. Capital Leases

The purpose of the balance sheet (aka the statement of position) is to enumerate the assets and liabilities of the firm as of a fixed point in time (usually the end of the fiscal or calendar year). Now certain liabilities are easy to identify and value: trade payables, wage withholdings, notes payable and lines of credit fall into this “easy” category. But liabilities involving income taxes and leases present more daunting measurement problems. Let’s discuss leases.

When you first think of leases you are apt to think of an office space or an automobile lease. But there are other types of leases such as equipment leases, computer systems being the most common. You would also tend to think that leases are not really liabilities at all. They are just ordinary periodic expenses so why would we bother putting them on the balance sheet at all? This is a good thought because most office space leases are relatively short term and can be voided by sub letting or outright cancellation. But equipment leasing is much more complicated because these leases are on closer examination in economic substance often seller financed purchases.

Substance over Form: Equipment Leasing as Disguised Asset Acquisition

It is not uncommon for firms who have borrowed funds from banks or other third party lenders to be subject to loan covenants that restrict their ability to borrow beyond certain limits.  Often these limits are stated in terms of debt coverage or debt to equity ratios. Managers subject to such limits may find themselves hamstrung in trying to finance needed large scale equipment acquisitions. The solution that was hit upon was to disguise outright seller financed acquisitions as leases. The accounting standards folks got wise to this ploy and set up rules that forced firms who were in substance acquiring fixed assets through seller financing to recognize the acquired equipment as an asset subject to depreciation and reflect the present value of future “lease” payments as an offsetting long term liability. Here is a very simplified example of how these rules work:

Example: The Out of Balance Beam Company is considering acquiring an expensive fabricating machine which ordinarily costs $100,000. They can arrange a “lease” which calls for sixty monthly lease payment of $1,900. At the end of the lease term the company can buy the equipment for $100.  Clearly this is in economic substance not a lease but a financed purchase.  The current accounting rules would force the company to record a $100,000 fixed asset and an offsetting $100,000 liability. The monthly “lease” payments would not be classified as an ordinary expense but would be allocated between principal repayment and interest expense.

You might wonder why managers would be upset with this accounting treatment because at least initially the asset entry would completely offset the liability. However, creditors do not necessarily see it this way. They recognize that often equipment once placed in service rapidly loses its collateral value relative the liability.

Distinguishing Between Operating and Capital Leases  

Operating leases transfer the right of use to the equipment or property to the lessee but after the lease term expires, the equipment is given back to the lessor. Since the lessor never owns the equipment, they do not assume the risk that is involved in ownership, which means for the lessee, the lease is an operating expense. This also means that there is no impact to the company’s balance sheet.

Capital leases however transfer ownership of the equipment to the lessor, allowing them to enjoy the benefits of ownership, but also the risks. Because the equipment is owned under a capital lease, it is recorded as both an asset and a liability on the balance sheet. A company can also claim depreciation and deduct the interest expense for the lease payment.

Current U.S GAAP outlines four conditions that can exist for a lease to be classified as a capital lease. The lease only needs to meet one of these conditions:

  • If the lease term is for longer than 75% of the equipment’s lifespan. 
  • If the equipment is transferred to the lessee upon expiration of the lease.
  • If the equipment is offered at a discounted price upon expiration of the lease.
  • If the value of the lease payments exceeds 90% of the equipment’s fair market value when discounted.

It should be noted, however, that the FASB and the International Accounting Standards Board is currently modifying the lease accounting standard to converge it with International Financial Reporting Standards.  Under the proposed new standards all leases of duration over twelve months would be treated as capital leases.


Some of the material in this post was provided by Erin Palmer from Bisk Education. Bisk was founded in 1971 by <a href="">Nathan Bisk</a>, CPA.  Erin is a writer and editor who reports on updates to Certified Public Accounting code, <a href="">CPA review</a> providers, and available <a href="">CPA CPE</a> providers.