The acquisition of assets in relation to costly capital equipment is a major life commitment form any firm. There is a need for proper planning of the acquisition of the funding procedure. Instead of paying for the assets with cash, it makes a lot of sense for businesses to look forward to spreading the cost for the acquisition of assets.
This coincides with the timing of the revenue created by the business.
Some typical sources for medium-term finance for investments in relation to capital assets include leasing and hire purchase terms. Leasing is a financial facility that allows a firm to make use of equipment within an allocated time frame in return for fixed and regular payments. The business chooses the specific equipment which is required with the finance firm paying for the asset on behalf of the business.
What is Leasing All About?
The basic characteristic of a lease deals with the ownership that never passes on to the business. However, the leasing firm takes claims of the capital allowances while passing on the benefits to the business through a manner of reduce rental charges.
Therefore, the business makes deductions for the full costs of the lease rentals as part of the taxable income included in the trading expense. Unlike hire purchase where the business takes full responsibility for the maintenance of the equipment.
Breaking Down Capital Leases and Operate Leases
Capital leases are treated as an asset on a firm’s balance sheet while an operating lease is an expense that is cleared off the balance sheet. You can think of a capital lease as more of owning a piece of property while an operating lease as more of renting out a property.
There are many differences that exist between a capital lease and an operating lease. However, there are two types of leases with the proper accounting treatment.
In terms of operating leasing, in case a business needs equipment for a short period of time, then the operating leasing is a practicable solution. The leasing form leases the equipment with expectations of the sale of the equipment upon closure of the lease agreement. The business, therefore, does not recover the full cost of the equipment with the lease rentals.
Accounting Treatment for Both Capital and Operating Lease
Both capital and operating lease are subject to various accounting treatment, especially to the lessor and lessee. In terms of the basics in the world of commercial financing, it can be understood from the perspective of the buyer only.
In terms of working out an operating lease, it makes for a more straightforward case. The lease payments are part of the operating expenses which are expensed together with the income statement. The business does not take charge of the asset therefore it is not included in the balance sheet. Hence, the business does not assess any of the depreciation for the asset. With a capital lease, it involves the transfer of ownership rights for the asset for the lessee.