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Companies can account for lease agreements as either operating expenses or capital investments. The decision impacts the company's financial statements and can be manipulated to present an inaccurate picture of its financial condition. In the US, Generally Accepted Accounting Principles (GAAP) that govern financial reporting for corporations set standards to control financial statement manipulation through lease agreement 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 business 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 agreement gives the company the right to use the equipment for a specific length of time with no right to ownership, the monthly payment is considered an operating expense. The expense is written off as an ordinary annual business expense and is reflected on the company's income statement.
If the lease agreement ends with the company owning the equipment or allows the company to buy the equipment at a reduced price at the conclusion 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 arrangement than it does with a true rental arrangement. 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 of the balance sheet. A rental payment on an income statement looks like a short-term expense that can be jettisoned at any time if the business needs to reduce expenses to preserve profitability. Conversely, a liability on the balance sheet affects the financial standing of the company, because it is an obligation with a multi-year impact that often cannot be canceled without significant cost.
GAAP lease accounting was modified to prevent balance sheet manipulation through lease misclassification. Financial standards in the US now require accountants to apply a four-prong test to lease agreements before classifying them as operating or capital. If a lease agreement contains any of the four test criteria, it should be properly classified as a capital obligation under GAAP lease accounting standards.
Two of the GAAP lease accounting criteria for capital leases concern the disposition of the equipment at the end of the contract. 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. Also, if the present value of the lease payments is more than 90 percent of the fair market value of the equipment or if the term of the lease is more than 75 percent of the life of the asset, the agreement is considered a capital obligation.