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Capital Lease vs. Operating Lease

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There are two kinds of accounting methods for leases: operating and capital
lease. A vast majority are operating leases. An operating lease is treated like
renting -- payments are considered operational expenses and the asset being
leased stays off the balance sheet. In contrast, a capital lease is more like a
loan; the asset is treated as being owned by the lessee so it stays on the
balance sheet. The accounting treatment for capital and operating leases is
different, and can have a significant impact on taxes owed by the business. A
capital lease is called a "finance lease" by the IFAC.

Finance vs Operating Lease redirects here.

Comparison chart

Capital Lease Operating Lease

Lease criteria - Ownership of the asset might be Ownership is retained by the
Ownership transferred to the lessee at the lessor during and after the lease
end of the lease term. term.

Lease criteria - The lease contains a bargain The lease cannot contain a
Bargain purchase option to buy the bargain purchase option.
Purchase Option equipment at less than fair
market value.

Lease criteria - The lease term equals or The lease term is less than 75
Term exceeds 75% of the asset's percent of the estimated
estimated useful life economic life of the equipment

Lease criteria - The present value of the lease The present value of lease
Present Value payments equals or exceeds payments is less than 90 percent
90% of the total original cost of of the equipment's fair market
the equipment. value

Risks and Transferred to lessee. Lessee Right to use only. Risk and
Benefits pays maintenance, insurance and benefits remain with lessor.
taxes Lessee pays maintenance costs

Accounting Lease is considered as asset No risk of ownership. Payments

(leased asset) and liability (lease are considered as operating
payments). Payments are shown expenses and shown in Profit
in Balance sheet and Loss statement

Tax Lessee is considered to be the Lessee is considered to be

owner of the equipment and renting the equipment and
therefore claims depreciation therefore the lease payment is
expense and interest expense considered to be a rental
expense

Contents: Capital Lease vs Operating Lease

1 What is a Lease? 2.1 Capital Lease Test
 3 Accounting for leases: Operating and Capital Lease 4.2 Advantages of a capital lease
4 Pros and Cons
5 References
4.1 Advantages of an operating lease

What is a Lease?
A lease is an agreement conveying the right to use
property, plant, and equipment (PP&E) usually for a
stated period of time. The party that gets the right to
use the asset is called a lessee and the party that
owns the asset but leases it to others is called the A For-Lease sign for a property
lessor.

Types of Leases
Various accounting standards recognize different kinds of leases. Standards govern the
classification not just the lessee but also for the lessor.

Types of Leases Recognized by Various Standards, as found in this FASAB report. The
IFAC recognizes Capital Leases but calls them Finance Lease.

In general, a capital lease (or finance lease) is one in which all the benefits and risks of
ownership are transferred substantially to the lessee. The legal owner (the holder of the
title) may still be the lessor. This is analogous to financing a car via an auto loan -- the
car buyer is the owner of the car for all practical purposes but legally the financing
company retains title until the loan is repaid.

Capital Lease Test

How does one choose between capital and operating leases for accounting? In
general, companies prefer operating leases. So the Financial Accounting Standards
Board (FASB) has imposed some restrictions on which leases can be treated as
operating leases. A lease must be treated as a capital lease if it meets any single one
of the following 4 conditions:

• Ownership: The lease transfers ownership of the property to the lessee by the
end of the lease term.
 • Bargain Price Option: The lease contains an option to purchase the leased
property at a bargain price.
• Estimated Economic Life: The lease term is equal to or greater than 75 percent
of the estimated economic life of the leased property.
• Fair Value: The present value of rental and other minimum lease payments,
excluding that portion of the payments representing executory costs, equals or
exceeds 90% of the fair market value of the leased property.

The last two criteria do not apply when the beginning of the lease term falls within the
last 25 percent of the total estimated economic life of the leased property.

If none of these criteria are met and the lease agreement is only for a limited-time use
of the asset, then it is an operating lease.

Accounting for leases: Operating and Capital Lease

Capital and operating leases receive different accounting treatment both for the lessor
and the lessee. We will focus on the lessee in this analysis. Under operating lease
accounting, the lessee does not own the asset, which has the following implications:

• Lease payments are considered operational expenses for the business.

• The asset/lease is not reported on the balance sheet.
• The firm cannot claim depreciation on the asset.

In contrast, accounting for a capital lease (or finance lease in IFAC terminology)
treats the lessee as the owner of the asset, which means:

• The lease is considered a loan. Interest payments are considered operational

expenses.
• The asset is included in the balance sheet: the outstanding loan amount (net
present value of all future lease payments) is included as a liability, and the
present market value of the asset is included as an asset.
• The lessee can claim depreciation on the asset every year.

The FASB and the IASB have proposed some changes to lease accounting rules that
would virtually eliminate operating lease accounting treatment for all companies that
lease real estate. The changes, proposed in 2012, are expected to take effect in 2015.
[1] The proposed standards will require assets and liabilities to be reported related to the
lease. To that extent, the leases will be similar to capital or finance leases. But there
are some differences in how these assets and liabilities are measured.

Pros and Cons

Advantages of an operating lease
• Operating leases provide much-needed flexibility to companies that frequently
update or replace their equipment.
• The lessee is protected from the risk of obsolescence.
• Accounting is simpler: the asset does not have to be included in the balance
sheet. The corresponding debt liability does not have to be calculated or included
either.
• Lease payments are operational expenses, so they are fully tax deductible.
• It provides improved Return On Asset (ROA) without capital budgeting restraints.

Advantages of a capital lease

• Capital leases recognize expenses sooner than equivalent operating leases. The
lessee is allowed to claim depreciation each year on the asset.
• In addition to depreciation, the interest expense component of the lease payment
can also be deducted as an operational expense.

References
• wikipedia:Finance lease
 • Primer on leases by Aswath Damodaran, Professor of Finance at the Stern School of Business
• A 2003 review of leases by FASAB

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Comments: Capital Lease vs Operating Lease
10 Comments Sort by Newest

Add a comment...

Asi Ya Naz · Teacher at Uswa Public School & College, Yultar, Skardu
Still in doubt please clear difference between operating and financial lease??
Like · Reply · Jun 10, 2017 8:50pm

Ashok Pradhan · Reader at EKAMRA COLLEGE,BHUBANESWAR

Thanks,comprehensive
Like · Reply · Dec 9, 2015 7:16pm

Amos Isaiah · Financial adviser at PHP Agency, Inc.

Thanks, very helpful.
Like · Reply · Jun 12, 2015 8:53pm

Boaz Abigail
Thanks for the info but I still have a question. Which one is better applied to a
company and why?
Like · Reply · 1 · Mar 12, 2015 8:53pm

Mulhat Hamza · Accountant at Mombasa, Kenya

nice one and keep it up forthe work.
Like · Reply · Mar 12, 2015 9:34am

Lizharriet Liz
thanks for the help.
Like · Reply · 1 · Jan 28, 2015 1:16am

Mohamed Kasem · Supervisor cost accountant at SESCO TRANS For Developed

Logistics S.A.E
very informative. thanx
Like · Reply · Jan 3, 2015 3:49pm

Paul Ulrich · University of Virginia

Capital Lease asset is a non current asset while there is a current portion of lease
payments.
Like · Reply · Aug 27, 2014 7:16am

James Payne · AME Zion University

thanks very much, now I understand the different between capital and operation
lease.
Like · Reply · Jul 19, 2014 7:45am

Solo Bob Tardey · Quality Administrator at Challenge Manufacturing

There are two kinds of accounting methods for leases: operating and capital lease. A
vast majority are operating leases. An operating lease is treated like renting
payments are considered operational expenses and the asset being leased stays off
the balance sheet. In contrast, a capital lease is more like a loan; the asset is treated
as being owned by the lessee so it stays on the balance sheet. The accounting
treatment for capital and operating leases is different, and can have a significant
impact on taxes owed by the business. A capital lease is called a finance lease.
Capital lease is where ownership of the asset might be transferred to the lessee at
the end of the lease term, while operating lease is where ownership is retained by
the lessor during and after the lease term.
Like · Reply · 2 · Feb 11, 2014 4:31pm

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Anonymous comments (1)

March 29, 2014, 3:59pm

Can anyone explain how capital lease decreases working capital

ratio?

— 99.✗.✗.27

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