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10.5. Capital lease

A longer-term lease transfers the risks and rewards of ownership to the lessee and therefore the accounting treatment is as if the asset had been sold, and the asset is included on the lessee's balance sheet. The lessee depreciates the asset over its life and allocates lease payments to payments of principal and interest.

Generally lessees prefer to structure leases as operating leases since this will give higher operating ratios and lower leverage, whereas lessors prefer to structure leases as capital leases since it allows earlier recognition of revenue and income.

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Other factors to consider include:

  1. The lessee only wants use of the asset for a relatively small part of its life.
  2. The lessor may be able to resell the asset more easily than the lessee.
  3. The tax benefits of owning assets will be of most benefit to a higher rate taxpayer.
  4. Bond covenants may limit the flexibility to increase debt; operating leases provide a way to finance off-balance-sheet.
  5. Management contracts may provide incentives based on the company's return on invested capital.

The following rules decide how leases should be classified.

Under U.S. GAAP, if any of the following conditions hold, a lease is classified as a capital lease.

  1. Otherwise it is classified as an operating lease on the lessee's accounts.
  2. Title is transferred to the lessee at the end of the lease period.
  3. The lease contains an option for the lessee to purchase the asset at a bargain price.
  4. The lease term is for 75% or more of the economic life of the asset (not applicable to land or when the lease term begins in the final 25% of the life of the asset).
  5. The present value of the minimum lease payments (MLPs), discounted at the minimum of the lessee’s incremental borrowing rate or the rate implicit in the lease, is equal to 90% or more of the fair value of the asset, adjusted for the tax credit received by the lessor.

IAS rules are less stringent and make it easier to classify a lease as an operating lease

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