Capital Lease vs Operating Lease

Difference Between Capital and Operating Lease

There are different accounting methods for the lease where in case of capital lease ownership of asset under consideration might be transferred at the lease term end to the lessee whereas in case of Operating lease ownership of asset under consideration is retained by lessor.

A lease is a contractual agreement between the lessor (owner of the asset) and the lessee (rents the asset). They are classified into two types depending on how the risk of ownership and benefits are transferred.

What is a Capital Lease?

It is also called financial Lease. A capital lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. In other words, the capital lease can be lease under which the present value of the minimum lease payments at the inception of the lease exceeds or is equal to substantially the whole of the fair value of the leased asset. It is a lease in which the lessee records the underlying asset as though its own asset, which means that the lessor is treated as a party that happens to be financing an asset that the lessee owns.

The lessor should treat a lease as a financial lease if any of the following criteria provided below are met:

There is an option to buy the leased asset; or
Lease period covers at least seventy five % of the useful life of the asset; or
Ownership of the leased asset shifts to the lessee following the lease expiration; or
The minimum present value of the lease payments totals at least ninety % of the fair value of the asset at the starting of the lease.

What is an Operating Lease?

The operating lease is stated as a lease agreement that does not involve the transfer of substantial risk and rewards of ownership of the asset leased to the lessee. It generally has a period that is significantly less than the fair value of the asset leased.

Leases that do not meet any of the four criteria are accounted for an Operating Lease

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Test 1: Transfer of ownership
Test 2: Bargain purchase option?
Test 3: Lease term > = 75% of economic life?
Test 4: Present value of payments >= 90% Fair Market Value?

If all of the criteria are true then it will be accounted for a capital lease.

Capital Lease vs Operating Lease Infographics

Analyst’s Perspective

Classification of Leases

A piece of equipment with a market price of (FMV) of US$100,000 and a useful life of 5 years is leased to a lessee for a period of 4 years. The lease payments are US$26,000 a year. The borrowing rate for the firm is 8%, and the rate implicit in the lease is 7%. There is no provision for a lessee to purchase an asset at the end of the lease term, nor any bargain purchase option.

Let us first look at whether this is a capital lease or Operating Lease. For understanding this, we perform the tests to determine the same.

Test 1 and Test 2 results in Operating Lease

Test 3 implies it is Capital Lease.

Test 4 implies this is an Operating Lease.

Overall, we know that if ANY of the tests is not met, then the lease is classified as Capital Lease.

Example

We will use the same example for the comparison.

A piece of equipment with a market price of (FMV) of US$100,000 and a useful life of 5 years is leased to a lessee for a period of 4 years. The lease payments are US$26,000 a year. The borrowing rate for the firm is 8%, and the rate implicit in the lease is 7%. There is no provision for Lessee to purchase an asset at the end of the lease term, nor any bargain purchase option.

Balance Sheet Effect

In the Operating Lease, there is NO balance sheet impact.
The balance sheet impact comes only in the Capital Lease.
Present value at 7% is $88,067
Both Asset and Liability increases by the present value of lease payments at the inception

Balance Sheet Effect as the payments are made is as per below

Book Value of Assets at the end of each year.

Please note that the following –

Depreciation (term of 4 years) = $88,067/4 = $22,017,
Principal repayments equal the lease payments LESS interest expense
The asset is being depreciated at a rate that is different from the rate of amortization for the liability, the two values are equal only at the inception and termination of the lease

Income Statement Effect

Operating income is higher for capital lease (This is because depreciation expense for capital lease is lower than the lease payments)
Net income is lower in the early years for a capital lease

Cash Flow Effect

In an operating lease, the total cash payment reduces cash flow from operations.
In a capital lease, the part of lease payment considered payment on principal reduces cash flow from financing activities
Total CF is unaffected by accounting treatment.

Key Differences

The net income will be higher in Operating lease in the initial years because the amount of depreciation and interest expenses will be higher in finance lease and as the lease comes to an end, the situation will reverse. However, the total Net income over the entire period of the lease will add up to the same number, under both categorisations as these are only reporting mechanisms.
EBIT is higher under Capital lease because a part of the lease payment is interest payment and this is reported below the EBIT and on the Income statement however the entire lease payment is reported above the EBIT under Operating lease.
CFO is higher for capital lease because a portion of the lease that goes towards a reduction in the debt liability is a part of the cash flow from financing and only interest forms part of the CFO. Further taxes are lower due to depreciation and the depreciation is added back. However, under Operating lease entire lease payment reduces the CFO and the tax is higher due to lack of depreciation expense
So naturally, CFF is lower for financial lease and higher for Operating lease, however over the entire lease period, the sum of the change in cash remains the same.

Capital Lease vs Operating Lease Comparative Table

Criteria/Item	Capital Lease	Operating Lease
Nature	This is an alternative to buying the PPE using debt-financing	This is an alternative to renting the PPE for a fixed rental payment
Impact on Income statement	Depreciation of the PPE and the interest on the debt financing are mentioned in the Income statement	Only rental payments are the expenses that are mentioned in the income statement
Impact on Balance sheet	The PV of the lease payments or the fair value of the PPE are reported on the balance sheet (whichever is lower). So the assets increase as the PPE is capitalized, the liabilities increase as the debt financing is added to it.	No impact is made on the balance sheet as the lease is purely expensed
Impact on Cash flow statement	Depreciation is added back as it is a non-cash expense and therefore CFO is higher Depreciation and interest reduce the profits and therefore lower taxes are paid in the initial years. Cash flow from financing activities is affected the debt financing and the principal repayments made for the debt used to finance the lease. Interest on the financing reduces CFO	As only lease payments are a part of the income statement, the taxes are higher so they reduce the CFO and the lease payments form a part of the CFO instead of cash flows from financing.
Off-balance sheet financing	As the asset is recorded in the balance sheet and the debt liability is created, the ratios such as return on asset and debt to equity ratio look smaller and may imply lack of efficiency or lower solvency.	As no asset is recorded in the balance sheet and no debt liability is created, the ratios such as return on asset ratio and debt to equity ratio look better.
Risk of obsolescence	At the end of the lease period, the ownership of the asset is transferred to the Lessee, so the risk of obsolescence is also transferred and if there is some technological innovation, which makes the asset obsolete by then the Lessee is stuck with it. So this risk is low for the Lessor and high for the Lessee	At the end of the lease period, the asset is returned to the Lessor, so the risk of obsolescence is low for the Lessee and high for the Lessor
US GAAP vs IFRS classification	US GAAP is more specific, as it mentions that there can be two types of leases under Capital lease and any one of the following conditions being met leads to a classification as Capital lease: Sale Type lease, at the end of which the ownership transfers and there is a profit for the Lessor because the PV of the payments is greater than the carrying value of the Leased PPE Direct Finance Lease is the one in which there is no profit, and the Lessor is only a financer for the Lessee. US GAAP requires that lease period is at least 75% of the useful life of the PPE PV of the lease payments is at least 90% of the fair value of the Lease asset Existence of a bargain purchase option IFRS mentions a more generic categorization saying that all risk and rewards should be transferred to the Lessee	Under US GAAP if none of the prerequisites of Capital lease is satisfied, then it is classified as an operating lease. IFRS mentions a more generic categorization saying that all risk and rewards should not be transferred to the Lessee.
Ratio Analysis	Lower Current & Asset turnover Ratios Lower Working capital Lower return on assets and equity Higher debt to equity and asset ratios	Higher Current and Asset turnover Ratios. Higher Working capital Higher return on assets and equity Lower debt to equity and asset ratios