When growing your small business, you may need to invest in assets to aid your day-to-day operations. Leases provide a way for you to use or acquire equipment without having to buy the asset outright. Capital leases come in two categories: direct financing and sales type leases. Familiarize yourself with both to see which one works best for your small business.

Capital Leases

Capital leases come in two forms: direct financing and sales-type leases. A capital lease allows the lessee to enjoy some of the benefits of ownership, such as claiming depreciation each year and deducting the interest component of the lease payments. However, leasing typically ends up more expensive for small businesses in the long run due to the lease charges added to the cost of the asset.

According to the Financial Accounting Standards Board, a lease qualifies as a capital lease if it meets one of four criteria at its inception. A capital lease must transfer ownership of the property to the lessee by the end of the lease term and have a “bargain purchase option” in which the lessee may pay for the asset at a reduced price, a lease term equal to 75 percent or more of the estimated economic life of the asset, or a present value of the lease at the beginning that exceeds 90 percent of the fair value of the asset.

Direct-Finance Lease

In a direct-finance lease, the carrying amount of the lease equals the fair market value of the leased asset. Therefore, the transaction does not result in a gain or loss, only interest revenue for the lessor. The lessor records the entry as a sale, removing the asset from its books and creating a receivable for the interest payments. The lessor determines the interest rate by calculating the internal rate of return for the asset.

Sales-Type Lease

In contrast to a direct-finance lease, a sales-type lease provides the dealer with a profit on the sale of the asset in addition to interest revenue earned. The profit derives from the difference between the fair value of the asset, or selling price, and the carrying value of the asset sold. The lessor uses the same accounting treatment as a direct-finance lease; however, profit is recognized at the inception of the lease.

Which One Is Right For You?

Which lease type works the best for you will depend on the nature of your small business. Companies that engage in direct financing often acquire assets with a plan to use the equipment to generate enough income to cover the lease payments as well as turn a profit. This allows small businesses to quickly earn income without having to make a large upfront investment.

Sales-type leases work well if your small business utilizes rapidly evolving technology or equipment. These leases reduce the risk of having large inventories of obsolete assets at their end of their useful life. If your small business uses a lot of computer equipment, consider a sales-type lease.