Deal Pack Blog
Accounting For Leases: Operating vs. Capital. What’s the Difference?
The term “leasing” is coming up more and more in the world of Buy Here Pay Here and for good reason. Many dealers are embracing the idea of leasing because it gives additional financing options to the buyer as well as a tax benefit to the dealer. Should you decide to offer a leasing program at your dealership you may first need to think about the best way to account for it on your books. Many dealers are unaware that there are multiple ways to book a lease and I hope to clear up any misconceptions before you get too deep.
There are two different methods used to account for a lease, ‘Operating’ and ‘Capital’. Operating, which is the preferred method for many used car dealerships, does not transfer any ownership of the asset to the lessee. Considered off balance-sheet financing, the asset stays with the dealer, not in the form of a receivable but as ‘Leased Inventory’. The benefit of keeping the leased inventory on your books is that the dealer may depreciate the value of the unit over the life of the lease. Another major benefit of this type of lease is that revenue is recognized as payments come in allowing the dealer to more accurately predict revenue streams and spread the amount of income tax due to the IRS over time.
Capital leases have virtually the same effect on your books as a retail deal in which inventory is expensed, revenue is earned, and a receivable is booked. The word Capital comes from the fact that the asset gets “Capitalized” at point of sale. When this happens, ownership is then transferred to the lessee given that the lease is non-cancellable and at least one of the following is met: 1. Title is transferred to lessee 2. The Lease contains a bargain purchase option, meaning that the residual payoff is set so low that it should almost guarantee a purchase at the end of the lease term 3. The term of the lease is equal to or greater than 75 percent of the estimated life of the vehicle 4. The present value of the total lease payments equals or exceeds 90 percent of the fair value of the vehicle. In addition to meeting this criterion, the dealer cannot take depreciation expense on a capital leases since ownership of the vehicle has transferred to the lessee.
There are clear differences between the two methods and each will have a significant impact on the way your financial statements are reflected. Consult your accountant first before making a decision. I would also recommend contacting your DMS to confirm that 1. The system can handle leasing and 2. It can handle the proper accounting for either operating or capital leases. If you are actively searching for a new DMS or you are new to the game, be sure to keep this in mind. Our DMS solution, Deal Pack, is fully capable of handling leases and offers real-time accounting that supports both accounting methods.