Leases have two classifications under US GAAP. A capital lease, now known as a finance lease, resembles a financed purchase; the lease term spans most of the asset’s useful life. An operating lease resembles a rental agreement in that the asset is used for a set time with useful life remaining at lease end.
Lease classification is determined by five criteria laid out under ASC 842, the new lease accounting standard, and dictates appropriate lessee and lessor accounting. This new standard now requires US GAAP entities to record both types of leases on the balance sheet.
Leasing is a popular alternative to purchasing assets outright that provides companies with flexibility and potential tax advantages. However, not all leases are created equal. There are two main types of leases in accounting – operating leases and capital leases. Understanding the key differences between capital leasing and operating leasing is crucial for making sound business decisions.
In this comprehensive guide, we will compare capital leases versus operating leases, analyzing their definitions, accounting treatments, financial statement impacts, advantages, and disadvantages Whether you are a lessee weighing leasing options or a lessor structuring lease agreements, this detailed comparison will provide invaluable insights. Let’s dive in!
What is a Capital Lease?
A capital lease, also known as a finance lease, is a long-term rental agreement that transfers substantially all the risks and rewards of asset ownership to the lessee Essentially, the lessee assumes the economic benefits and risks associated with owning the asset, even though the lessor retains legal title.
According to GAAP accounting standards, a lease qualifies as a capital lease if it meets one or more of the following criteria:
- Transfer of Ownership – The lease agreement allows ownership of the asset to be transferred to the lessee at the end of the lease term.
- Bargain Purchase Option – The lease agreement contains a bargain purchase option allowing the lessee to buy the asset at a discounted price at the end of the lease term.
- 75% Useful Life – The lease term covers 75% or more of the estimated economic life of the asset.
- 90% of Fair Value – The present value of the minimum lease payments equals or exceeds 90% of the fair value of the asset.
If a lease meets any one of these requirements, the lessee must account for the arrangement as a capital lease rather than an operating lease
Key Features of a Capital Lease
Beyond meeting the GAAP criteria above, capital leases have several other distinctive features:
- On-Balance Sheet – The leased asset is capitalized on the lessee’s balance sheet, reflecting ownership. An offsetting lease liability is recorded.
- Asset Ownership – The lessee assumes substantially all the risks and rewards of ownership.
- Longer Lease Term – The lease term often covers a major part of the asset’s useful economic life.
- Lease Payments – Lease payments are allocated between principal repayment and interest expense.
- Depreciation Expense – The lessee depreciates the leased asset over the lease term.
- Executory Costs – The lessee commonly bears executory costs such as maintenance and taxes.
What is an Operating Lease?
In contrast to a capital lease, an operating lease is treated as a rental agreement rather than a purchase. With an operating lease, the lessee does not assume the risks and rewards of ownership. Here are some key features of operating leases:
- Off-Balance Sheet – The leased asset remains off the lessee’s balance sheet.
- Rental Agreement – The lessee has the right to use an asset for a period in exchange for rental payments.
- Shorter Lease Term – The lease term is shorter than the asset’s economic life.
- No Ownership – Ownership of the asset remains with the lessor.
- Lease Expense – The lessee records a lease expense on the income statement for rental payments.
- Lessor Responsibilities – The lessor typically retains maintenance and service responsibilities.
- Tax Treatment – Rental payments are treated as tax-deductible operating expenses.
Operating leases provide greater flexibility since the lessee is not locked into long-term ownership but has the right to use the asset as needed.
Capital Lease vs. Operating Lease: Key Differences
Now that we have defined capital leases and operating leases, let’s recap the major differences:
| Capital Lease | Operating Lease |
|---|---|
| On-balance sheet | Off-balance sheet |
| Transfers ownership | No ownership transfer |
| Longer lease term | Shorter lease term |
| Lessee bears executory costs | Lessor bears executory costs |
| Lease payments allocated to principal & interest | Lease payments treated as rent expense |
| Lessee depreciates leased asset | No depreciation by lessee |
While capital leases are treated similarly to an asset purchase, operating leases are accounted for as simple rental agreements. This leads to very different impacts on the financial statements.
Financial Statement Impact
The way capital leases and operating leases are recorded and presented on the financial statements varies significantly:
Balance Sheet
- Capital Lease – The leased asset is capitalized as a fixed asset. A corresponding lease liability is recorded as a liability.
- Operating Lease – No asset or liability is recorded. Only short-term and low-value leases may be accounted for differently.
Income Statement
- Capital Lease – Depreciation and interest expenses are recorded.
- Operating Lease – A lease expense equal to the rental payments is recorded.
Cash Flow Statement
- Capital Lease – Repayments of principal are financing cash outflows. Interest is an operating cash outflow.
- Operating Lease – Lease payments are operating cash outflows.
Capital Lease Accounting Example
Let’s look at a simple example to illustrate the accounting for a capital lease:
- Company A enters into a 5-year capital lease for equipment with annual lease payments of $20,000.
- The equipment has a 10-year useful life and a fair value of $100,000.
- Company A’s incremental borrowing rate is 6%.
The present value of the minimum lease payments equals the fair value of the equipment ($100,000). This meets the 90% fair value test, so the lease is a capital lease.
On commencement, Company A would make the following accounting entries:
Lease Asset Dr $100,000<br>
Lease Liability Cr $100,000
The asset and liability are recorded at the present value of $100,000.
Over the lease term, Company A would record:
- Depreciation expense on the asset (straight-line over 10 years = $10,000 annually)
- Interest expense on the lease liability (based on the 6% implicit rate)
- Lease payments (allocated between principal and interest)
By the end of the lease, the asset and liability balances reach zero.
Key Benefits of Capital Leases for Lessees
Capital leases have some potential advantages from the lessee’s perspective:
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Asset Use – The lessee gains long-term access and control over the asset.
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Off-Balance Sheet – Keeps leased assets off the balance sheet compared to purchasing.
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Financing – May provide 100% financing for asset acquisition.
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Taxes – Interest expense may be tax deductible, providing a tax shield.
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Obsolescence Risk – Avoids the risk of obsolescence for high-tech assets.
However, these benefits must be weighed against the higher cost structure and risks associated with capital leases.
Key Drawbacks of Capital Leases for Lessees
There are also some potential disadvantages or risks to consider with capital leases:
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Higher Costs – Effective borrowing costs are usually higher than conventional financing.
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Inflexibility – Lessee is locked into long-term commitment and ownership.
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Complex Accounting – More complex accounting treatment than operating leases.
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Asset Maintenance – Lessee bears costs of maintenance, taxes and insurance.
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Penalties – Early termination may trigger penalties.
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Financial Risk – Adds financial leverage and asset risk to the balance sheet.
Key Takeaways – Capital Lease vs Operating Lease
- Capital leases transfer ownership risks/rewards to the lessee whereas operating leases do not.
- Capital leases are capitalized on the balance sheet; operating leases are kept off.
- Lease expenses and cash flows differ significantly between capital and operating leases.
- Capital leases have greater risks/costs but may provide tax and financing advantages.
- Operating leases provide simplicity and flexibility but lose out on ownership benefits.
Carefully weighing the pros and cons of each type of lease is crucial, as the accounting treatment and financial statement impacts differ greatly. Assessing organizational needs, asset characteristics, taxation factors and the desired balance sheet profile will help determine when a capital lease or operating lease is more suitable. With this overview of the critical differences between capital leasing and operating leasing, both lessees and lessors can make fully-informed leasing decisions.
Capital/finance lease vs. operating lease accounting treatment
Both finance and operating leases represent cash payments made for the use of an asset. However, because of the distinction between the two types of leases, it is worth mentioning the differences in the mechanics of the accounting for each.
The cash payments made for each lease must have a corresponding expense. This expense represents the lease cost and may differ slightly from the cash payment made each period.
Operating lease payments under ASC 840 were often recorded to rent expense as simply a debit to expense and a credit to cash. Operating lease accounting under ASC 842 is more complex. To summarize, a right-of-use asset and a lease liability must be established at lease commencement (or transition to ASC 842), and then reduced over the remaining lease term in addition to recording the cash payment and lease expense.
The total lease expense booked under ASC 842 for operating leases is comprised of an asset lease expense and a liability lease expense and is equal to the total amount of required cash payments allocated evenly over the lease term. The liability lease expense represents the interest accrued on the lease liability each period and the asset lease expense represents the amortization of the lease asset.
The lease liability is reduced by the periodic cash payment, less any interest accrued on the lease liability balance. The lease asset is reduced by the periodic lease asset expense. Below is an example of an operating lease amortization schedule showing:
(2) Liability lease expense
(4) Asset lease expense, and
(5) Total lease expense under ASC 842:
Accounting for finance leases under ASC 842 is much the same as capital lease accounting under ASC 840. Similar to operating leases, a right-of-use asset and lease liability must be established at lease commencement (or transition to ASC 842), and then reduced over the remaining lease term.
The finance lease liability is treated as capital lease liabilities were – the lease payments are split between the interest expense incurred on the lease liability and a lease liability reduction amount. The right-of-use asset is reduced by amortization expense like capital lease assets were reduced by depreciation expense. Below is an example of a finance lease amortization schedule under ASC 842:
Are you looking for more detail on finance and operating lease accounting under ASC 842? Our Ultimate Lease Accounting Guide includes 44 pages of comprehensive examples, disclosures, and more.
Transfer of title/ownership to the lessee
Criteria: Transfer of ownership occurs by the end of the lease term. This is commonly seen in equipment or vehicle leases where at the conclusion of the lease term, the lessor relinquishes the title to the asset and ownership of the asset transfers to the lessee.
This criterion is the same from ASC 840 to ASC 842. If title transfers to the lessee, then the lease is classified as finance.
Operating vs Capital Lease
What is capital lease VS operating lease?
There are different accounting methods for the lease. For example, in the case of a capital lease, ownership of the asset under consideration might be transferred at the lease term end to the lessee.
What is the difference between a finance lease and a capital lease?
A finance lease and a capital lease refer to the same type of lease agreement. While the terminology may vary depending on the jurisdiction or accounting standards being applied, both terms describe a lease arrangement where the lessee assumes most of the risks and rewards associated with ownership of the leased asset.
How do you classify a lease as a capital lease?
In order to classify a lease as a capital lease or operating lease, specific criteria should be met. A capital lease should meet the following criteria: Ownership of the asset can be transferred to the lessee at the end of the lease term. Lessee can buy the asset at a discount, at a price less than the asset’s market value, at lease termination.
How does a capital lease work?
Capital lease In a capital lease, the lessee can buy the lessor’s asset at lease termination at a discount and take ownership of the asset, and the lessor is required to transfer his asset and get the asset’s negotiated selling price from the lessee in this case. Capital leases have intermediate to longer-term duration.
