Lease classification as operating expenses or capital investments affects financial statements and can be manipulated. GAAP lease accounting requires a four-prong test to determine classification, with capital leases creating assets and liabilities on balance sheets. Two GAAP criteria for capital leases relate to equipment disposition and lease payment value.
Businesses can account for leases as operating expenses or capital investments. The decision affects the company’s financial statements and can be manipulated to present an inaccurate picture of its financial situation. In the US, the Generally Accepted Accounting Principles (GAAP) governing financial reporting for corporations establish standards to control manipulation of financial statements through lease classification. GAAP lease accounting requires accountants to apply a four-prong test to a lease to determine whether it should be classified as an operating or capital obligation.
There are two types of commercial leases in general, which include operating leases and capital leases. A lease agreement allows a company to rent equipment for a monthly payment without purchasing the equipment outright. If the lease gives the company the right to use the equipment for a specified period without ownership, the monthly payment is considered an operating expense. The expense is written off as an ordinary annual business expense and is reflected in the company’s income statement.
If the lease terminates with the company that owns the equipment or allows it to purchase the equipment at a reduced price at the end of the lease term, the lease is considered a capital obligation. In this scenario, the lease has more in common with a long-term financing agreement than an actual rental agreement. A capital lease creates an asset and a liability on the corporation’s balance sheet. The company must depreciate the asset each year and can only deduct the interest paid on the lease.
Corporations tend to prefer to classify leases as operating expenses to keep them off the balance sheet. A rent payment on an income statement seems like a short-term expense that can be scrapped at any time if the business needs to cut expenses to preserve profitability. In contrast, a liability on the balance sheet affects the financial position of the company, because it is an obligation with an impact of several years that often cannot be settled without significant cost.
GAAP lease accounting was amended to prevent balance sheet manipulation through lease misclassification. Financial regulations in the United States now require accountants to apply a four-prong test to lease agreements before classifying them as operating or capital. If a lease contains any of the four test criteria, it should be appropriately classified as a capital obligation under GAAP lease accounting standards.
Two of the GAAP lease accounting criteria for capital leases refer to the disposition of the equipment at the end of the lease. If the company owns the equipment or has an option to purchase the equipment at a bargain price at the end, the lease is considered capital. In addition, if the present value of the lease payments is more than 90 percent of the fair market value of the equipment or if the lease term is more than 75 percent of the life of the asset, the arrangement is considered a capital obligation. .
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