Types Of Lease
Operating leases “generally provide for both financing and maintenance” (Brigham & Ehrhardt, 2017, p. 792). The lessor (the one that owns the leased equipment) must therefore make sure the leased equipment has regular maintenance and is kept in good condition. The lessor often builds the cost of maintaining the equipment into the lease to cover these expenses. Operating leases are also not fully amortized. It is not likely that the term of the leased asset will pay off the cost of the asset in its entirety. Instead it is more likely to recoup the full cost by extending the lease or leasing the asset to someone else. Finally, operating leases often include cancellation clauses so that the lessee can cancel early if need be.
A capital lease “is a lease of business equipment which represents ownership and is reflected on the company’s balance sheet as an asset” (Murray, 2019, Para. 4). Capital leases do not provide maintenance, are not cancelable, and are fully amortized (Brigham & Ehrhardt, 2017). Capital leases are used for long-term purposes and equipment is treated as assets to the company so can be depreciated. Capital leases often contain a clause where the title passes to the lessee once the lease is paid off, or there is an option to purchase the equipment as the end of the lease for less than fair market value; often for $1.
Operating leases are considered expenses and capital leases are considered assets. Capital leases may be eligible for depreciation, wherein operating leases are not. The best option; capital vs operating, depends on your situation. If you are looking for a long-term asset, a capital lease is probably better. You can depreciate the asset which reduces taxable income. Interest expense on the lease would also reduce the taxable income. The item is used for a long period of time and can be purchased for cheap at the end of the lease. If you are looking for a short-term asset, an operating lease is probably better. That way you are not holding onto an asset that may become obsolete and the lease payments for the asset are tax- deductible.
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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