There are two basic types of leases in the world of accounting. They are operating leases and capital leases. Leases that have one or more of the following provisions are defined as capital leases:
- The lease transfers ownership of the leased asset to the lessee at the end of the lease term.
- The lease contains an option for a bargain purchase of the leased asset by the lessee.
- The lease term extends over most of the economic life of the leased asset.
- The lease requires rental payments which approximate the fair market value of the leased asset.
The capital lease is accounted for as a purpose of the asset. Consequently, when the lease is executed, the lessee will debit a fixed asset account for the fair market value of the asset, and would set up a long-term lease liability.
Operating leases are all the other leases that do not meet one or more of the above conditions to be a capital lease. Operating leases are accounted for by recognizing rent expense as the leased asset is used.
A leasehold is the right to use, for a certain amount of time (more than a year), a fixed asset. This is usually a building or part of a building. A leasehold improvement would be any improvement made to the leasehold that may not be removed when the lease expires. Examples include new walls, central air conditioning or new fixtures.
Leaseholds and leasehold improvements are accounted for in the same manner as depreciation. However, straight-line is used as accelerated methods are not allowed for income tax purposes. This systematic write-off is called amortization. When the life of the fixed asset is longer than the life of the lease, the amortization will be for the life of the lease.