When looking to lease machinery, equipment, or pretty much anything for your business you’ll be presented with a few different options. They can be pretty overwhelming. They’re also decisions that can impact the cash flow of your business for years to come.
When looking to lease, you need to consider both a capital lease, and an operating lease. However, you should also know that a capital lease has now become a finance lease.
You also need to ensure you account for a finance lease properly, in line with ASC 842 lease accounting guidelines. A lot of business owners struggle with guideline updates and accounting, so if you’re doing it yourself you need to spend time on understanding the guidance and the chande and to make sure the right leases are recorded on the balance sheet.
So, let’s take a look at why capital leases are now known as finance leases.
What’s A Capital Or Finance Lease
A capital lease is essentially a lease known or characterized as an owned asset. It’s also known as a finance lease under the newer ASC 842 finance agreements. When accounting for a capital/finance lease, the lessee (person lending the item) records the item as if they’d purchased it using funding by the lessor (lender of the item). This is of course different to how you would record use of an operating lease.
Why Is It Different To An Operating Lease?
An operating lease functions like a rental agreement. The person leasing the item (lessee) pays to use the asset but doesn’t own it or benefit from ownership benefits. At the same time, they also don’t incur any risks involved with ownership either. Operating lease differs from the capital (now finance) lease.
Operating leases have their pros though. For instance, they allow companies to readily upgrade their equipment where necessary by upgrading it. If you operate in a tech industry where there are always newer iterations available to better serve the customer, then logically an operating lease will be better suited to you. By doing this, you avoid the risk of obsolescence. If you buy something or have something with the characteristics of ownership then it’s going to be exposed to not only depreciation, but also be at risk of being outpaced.
The downside is that you’re tying yourself and your business into a lengthy contract and payment. Also, your payments don’t build equity in the product because you’re leasing it. So if it is something that retains value and doesn’t suffer from becoming obsolete you could be losing out.
Capital Vs Finance Lease
So, with ASC 842 taking over the older standard of ASC 840, why are capital leases now being referred to as a finance lease? It can be confusing and is one of the greatest changes as a result of the new lease accounting standards. When looking at a capital lease vs finance lease, the change reason is simple: the majority of leases will now be capitalized. The name “capital lease” is of course no longer accurate.
Why Did They Change To ASC 842
The change was driven by a need for consistency across the board in financial reporting from a lease accounting standard point of view. It puts more leases on the balance sheet, with a few exceptions while trying to reduce off balance sheet activities. It actually came into force in 2018 for public companies and 2021 for private companies, so it’s been around for a few years depending on your point of view. Any companies reporting under US GAAP will have to conform to ASC 842.
People, even accountants, will still refer to them as capital leases. It leads to confusion and even mistakes when completing your lease accounting. There is, of course, accounting software that can help you out, or you can hire an accountant to help you. The key is in ensuring you understand the new lease accounting standards before rushing to put your accounts together.
If you lease machinery, computing equipment, etc this will be important to you. Usually, newer business tend to lease more equipment than older ones. However, some will just keep entering into new lease agreements on a rolling basis to keep the newest equipment possible. In these situations, it’s easy to miss new lease accounting guidance and keep applying old rules.
In short there is a difference between a finance lease and a capital lease and it pays to check your current business accounting work practices to ensure you’re compliant with ASC 842 lease accounting guidelines.