Are Equipment Rentals Capitalized? Understanding the Accounting Treatment

In the world of accounting and finance, the treatment of expenses and assets can significantly impact a company's financial statements and overall financial health. One common question that arises, especially for businesses that rely on equipment for their operations, is whether equipment rentals should be capitalized. This article delves into the concept of capitalization, the criteria for capitalizing expenses, and whether equipment rentals meet these criteria.

Understanding Capitalization in Accounting

Capitalization in accounting refers to the process of recording a cost as an asset on the balance sheet rather than expensing it immediately on the income statement. The rationale behind capitalization is that the cost incurred will provide economic benefits to the company over multiple accounting periods. By capitalizing an expense, a company spreads the cost over the useful life of the asset, which aligns with the matching principle in accounting.

Key Criteria for Capitalization

For an expense to be capitalized, it generally must meet the following criteria:

1. Future Economic Benefit: The expense must provide future economic benefits to the company. This means that the asset will contribute to generating revenue or reducing costs over its useful life.

2. Measurability: The cost of the asset must be measurable with reasonable accuracy. This includes not only the purchase price but also any additional costs necessary to prepare the asset for its intended use.

3. Useful Life: The asset must have a useful life that extends beyond the current accounting period. Typically, this means the asset will be used for more than one year.

4. Ownership or Control: The company must have ownership or control over the asset. This is a critical factor in determining whether an expense should be capitalized or expensed.

Equipment Rentals: To Capitalize or Not?

When it comes to equipment rentals, the decision to capitalize or expense the cost depends on the nature of the rental agreement and the criteria mentioned above.

Operating Leases vs. Capital Leases

The accounting treatment of equipment rentals largely depends on whether the rental agreement is classified as an operating lease or a capital lease (also known as a finance lease).

Operating Leases

An operating lease is a rental agreement where the lessee (the company renting the equipment) does not assume the risks and rewards of ownership. In an operating lease:

• The lessor (the owner of the equipment) retains ownership and control over the asset.
• The lease term is typically shorter than the useful life of the equipment.
• The lessee does not have the option to purchase the equipment at the end of the lease term.

Under an operating lease, the rental payments are treated as operating expenses and are recorded on the income statement as they are incurred. The equipment itself is not capitalized on the lessee's balance sheet because the lessee does not have ownership or control over the asset.

Capital Leases

A capital lease, on the other hand, is a rental agreement that transfers substantially all the risks and rewards of ownership to the lessee. A lease is classified as a capital lease if it meets any of the following criteria:

1. Ownership Transfer: The lease agreement includes a provision that transfers ownership of the equipment to the lessee at the end of the lease term.

2. Bargain Purchase Option: The lease agreement includes a bargain purchase option, allowing the lessee to buy the equipment at a price significantly lower than its fair market value at the end of the lease term.

3. Lease Term: The lease term is for the major part of the economic life of the equipment (typically 75% or more).

4. Present Value of Lease Payments: The present value of the lease payments equals or exceeds substantially all of the fair market value of the equipment (typically 90% or more).

If a lease meets any of these criteria, it is classified as a capital lease, and the lessee must capitalize the leased equipment on their balance sheet. The lessee records the equipment as an asset and the lease obligation as a liability. The asset is then depreciated over its useful life, and the lease payments are allocated between interest expense and reduction of the lease liability.

Impact on Financial Statements

The classification of an equipment rental as an operating lease or a capital lease has significant implications for a company's financial statements.

Operating Lease

• Income Statement: Rental payments are recorded as operating expenses, reducing net income in the period they are incurred.
• Balance Sheet: The equipment is not recorded as an asset, and there is no corresponding liability. This results in a lower asset base and no impact on the company's debt-to-equity ratio.
• Cash Flow Statement: Rental payments are classified as operating cash outflows.

Capital Lease

• Income Statement: The company records depreciation expense on the capitalized asset and interest expense on the lease liability. This can result in higher expenses in the early years of the lease compared to an operating lease.
• Balance Sheet: The equipment is recorded as an asset, and the lease obligation is recorded as a liability. This increases both the asset base and the liabilities, potentially affecting financial ratios such as the debt-to-equity ratio.
• Cash Flow Statement: The principal portion of the lease payments is classified as a financing cash outflow, while the interest portion is classified as an operating cash outflow.

Recent Changes in Lease Accounting Standards

It's important to note that lease accounting standards have undergone significant changes in recent years, particularly with the introduction of the International Financial Reporting Standards (IFRS) 16 and the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 842. These new standards have changed the way leases are classified and reported, particularly for operating leases.

IFRS 16 and ASC 842

Under IFRS 16 and ASC 842, lessees are required to recognize most leases on their balance sheets, regardless of whether they are classified as operating or finance leases. This means that even operating leases, which were previously off-balance-sheet, must now be capitalized.

• IFRS 16: Effective for annual reporting periods beginning on or after January 1, 2019, IFRS 16 requires lessees to recognize a right-of-use asset and a corresponding lease liability for all leases with a term of more than 12 months, unless the underlying asset is of low value.

• ASC 842: Effective for public companies for fiscal years beginning after December 15, 2018, and for private companies for fiscal years beginning after December 15, 2021, ASC 842 requires lessees to recognize a right-of-use asset and a lease liability for all leases with a term of more than 12 months.

Implications of the New Standards

The new lease accounting standards have several implications for companies that rent equipment:

1. Increased Asset and Liability Recognition: Companies must now recognize right-of-use assets and lease liabilities for most leases, which increases the total assets and liabilities reported on the balance sheet.

2. Impact on Financial Ratios: The capitalization of operating leases can affect key financial ratios, such as the debt-to-equity ratio, return on assets, and interest coverage ratio. This may impact how investors and creditors view the company's financial health.

3. Complexity in Accounting: The new standards require more detailed disclosures and calculations, increasing the complexity of lease accounting. Companies may need to invest in new systems or software to comply with the new requirements.

4. Tax Implications: The capitalization of leases may also have tax implications, as the treatment of lease payments for tax purposes may differ from their treatment for accounting purposes.

Practical Considerations for Businesses

Given the complexities and implications of lease accounting, businesses that rent equipment should carefully consider the following:

1. Lease Classification: Determine whether the equipment rental agreement qualifies as an operating lease or a capital lease under the applicable accounting standards. This classification will dictate the accounting treatment and financial statement impact.

2. Compliance with New Standards: Ensure compliance with the latest lease accounting standards, such as IFRS 16 and ASC 842. This may involve updating accounting policies, systems, and processes to accurately record and report leases.

3. Impact on Financial Statements: Assess the impact of lease capitalization on the company's financial statements and key financial ratios. This is particularly important for companies that rely on external financing or have debt covenants tied to financial metrics.

4. Tax Planning: Consider the tax implications of lease capitalization and work with tax advisors to optimize the company's tax position.

5. Lease vs. Buy Decision: Evaluate whether it makes more sense to lease or buy equipment based on the company's financial situation, cash flow needs, and long-term strategic goals. In some cases, purchasing equipment may be more advantageous from a financial and operational perspective.

Conclusion

In summary, whether equipment rentals are capitalized depends on the nature of the rental agreement and the applicable accounting standards. Under traditional accounting rules, operating leases are expensed as incurred, while capital leases are capitalized on the balance sheet. However, with the introduction of new lease accounting standards such as IFRS 16 and ASC 842, most leases, including operating leases, must now be capitalized.

Businesses must carefully evaluate their equipment rental agreements, comply with the latest accounting standards, and consider the financial and tax implications of lease capitalization. By doing so, companies can ensure accurate financial reporting, maintain compliance with regulatory requirements, and make informed decisions about their equipment needs.

Ultimately, the decision to capitalize equipment rentals is not just an accounting exercise but a strategic consideration that can impact a company's financial health and operational efficiency. As such, it is essential for businesses to work closely with their accounting and financial advisors to navigate the complexities of lease accounting and make the best decisions for their unique circumstances.