A company can lease its long-term assets to other businesses according to the arranged leasing agreements. This allows the company to enjoy tax benefit perks. Yet companies have the habit of not reporting the lease payments in its accounting books, creating a misrepresentation of the company's true financial situation. Accounting rules developed by the Financial Accounting Standards Board (FASB) requires a company to report its leases in all accounting reports, such as balance sheets and income statements, based on the type of lease.
Operating Lease
A company creates an operating lease when it wishes to allow the right for the lessee to use property, but the lessee does not take any financial risk of ownership toward the property. This type of lease agreement has a set period. Once the lease is over, the property returns to the company. The company reports the lease expenses on income statements but not on the balance sheet.
Capital Lease
When a company creates a capital lease, the company allows the lessee to take on the risk of ownership of the property to receive tax benefits. The company reports this arrangement on the balance sheet, since the lease payments are both assets and liabilities on financial statements. Many companies do not like this arrangement, preferring to keep lease payments off their financial books and not have the expenses incurred as debts to lessen the company's financial strength.
FASB Ruling
To complicate the matter of the company properly reporting leases on financial statements, the FASB has standards on classify the lease when it is a capital lease. The lease must meet only one of the following criteria. The life of the lease has to be longer than 75 percent of the asset. The ownership of the property must transfer back to the lessee at the lease's end. The company can offer the lessee to purchase the asset at the end of the lease, for a discount price and if the lease payment value is more than 90 percent of far market value after the appropriate discount rate has been applied.
Reclassifying Leases
Some companies prefer to classify the lease as an operating lease to obtain tax benefits and not report expenses. But the operating lease may actually be seen as a capital lease by the FASB ruling, which increases the debt reported on the balance sheet and can have a significant impact on companies that rely heavily on establishing operating leases, such as airlines and retail businesses.
