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Capital Lease vs Operating Lease

Accounting treatment for capital lease and operating lease

Capital Lease vs Operating Lease

A capital lease (or finance lease) is treated like an asset on a company’s balance sheet, while an operating lease is an expense that remains off balance sheet. Think of a capital lease like owning a property and think of an operating lease like renting a property. There are significant differences between a capital lease vs operating lease and this guide will help you understand the difference between the two types of leases and their respective accounting treatment.

 

Capital Lease vs Operating Lease

 

Capital leases are counted as debt. They depreciate over time and incur interest expense.

To be classified as a capital lease, any one of four conditions must be met:

  1. A transfer of ownership of the asset at the end of the term
  2. An option to purchase the asset at a discounted price at the end of the term
  3. The term of the lease is >75% of the useful life of the asset
  4. The present value of the lease payments is >90% of the asset’s fair market value

 

Operating leases are used for short-term leasing of assets and are similar to renting, as they do not involve any transfer of ownership. Periodic lease payments are treated as operating expenses and are expensed on the income statement, impacting both the operating and net income. In contrast, capital leases are used to lease longer-term assets and give the lessee ownership rights.

 

Accounting Treatment: Capital Lease vs Operating Lease

Capital and operating leases are subject to different accounting treatment for both the lessee and the lessor. For the purpose of entry-level finance interviews, it is enough to understand the accounting treatment for the lessee only.

Accounting for an operating lease is relatively straightforward. Lease payments are considered operating expenses and are expensed on the income statement. The firm does not own the asset and, therefore, it does not show up on the balance sheet and the firm does not charge any depreciation.

In contrast, a capital lease involves the transfer of ownership rights to the asset to the lessee. The lease is considered a loan (debt financing), and interest payments are expensed on the income statement. The present market value of the asset is included in the balance sheet under the assets side and depreciation is charged on the income statement. On the other side, the loan amount, which is the net present value of all future payments, is included under liabilities.

In general, capital leases recognize expenses sooner than equivalent operating leases.

 

Accounting Treatment: Capital Lease vs Operating Lease

 

Advantages of a Capital Lease

There are many advantages to a capital lease, including the following:

  • Lessee is allowed to claim depreciation on the asset, which reduces taxable income
  • Interest expense also reduces taxable income
  • Firms in a higher tax bracket are more likely to classify a lease as a capital lease

 

Advantages of an Operating Lease

There are many advantages to an operating lease as well:

  • Operating leases provide greater flexibility to companies as they can replace/update their equipment more often
  • No risk of obsolescence, as there is no transfer of ownership
  • Accounting for an operating lease is simpler
  • Lease payments are tax deductible
  • Firms in a lower tax bracket are more likely to classify a lease as an operating lease

 

Conclusion

As both capital and operating leases are commonly used by companies, it is useful to gain an understanding of the accounting and commensurate tax treatment for each of these types of leases for both the lessor and the lessee. Each type of lease comes with its own advantages. Depending on the company’s requirement and tax situation, they may opt for one or the other, or possibly even a combination of both for different types of assets.

 

Other Resources

CFI is the global provider of the Financial Modeling and Valuation Analyst designation, designed to help anyone become a world-class financial analyst. To continue learning more about other accounting issues, please see these additional resources:

  • Lease Accounting
  • Prepaid Lease
  • Fixed and Variable Costs
  • Projecting Balance Sheet Items

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