Capital Lease Vs Operating Lease

Updated on April 24, 2024
Article byWallstreetmojo Team
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

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. In contrast, in the case of Operating Lease ownership of the asset under consideration is retained by the lessor.

Capital Lease Vs Operating Lease

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A lease is a contractual agreement between the lessor (owner of the asset)Lessor (owner Of The Asset)A lessor is an individual or entity that leases out an asset such as land, house or machinery to another person or organization for a certain period.read more and the lessee (rents the asset). They are classified into two types depending on how the risk of ownership and benefits are transferred.

Capital Lease Vs Operating Lease Explained

The capital lease vs operating lease guide us regarding the points of differences between the two types of lease agreements. Both of them are widely used in business in order to acquire assets. They are different in terms of accounting process followed, nature of the lease and also regarding ownership transfer.

The capital lease is structured or designed like that of a purchase or any financing agreement. It is a lease agreement for long term and the risk and rewards of the ownership is on the lessee. The lessee can buy the asset at the end of the agreement. But in an operating lease, the lessor allows the lessee to use the asset for a certain number of years, which is typically less than the life of the asset. In this the lessee doe s not get the optio to buy the asset at the end of the agreement.

There are various other criterias that contribute to distinguishing the two concepts of operating lease vs capital lease. One such criteria is the accounting standard followed, which may be International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP). They take into account the terms and conditions, the fair value of the asset and the present value of the payment.

The companies should carefully analyse the financial requirement and objectives along with the terms of the agreement before selecting the type of lease. This is because the financial reporting methods and the rights to ownership will vary based on them. Consulting a legal and accounting professional is always helpful.

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What Is a Capital Lease?

It is also called a financial lease. A capital lease is a lease that transfers all the risks and rewards incidental to ownership of an asset substantially. In other words, the capital lease can be a 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 lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. read more records the underlying asset as its 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 finance leaseTreat A Lease As A Finance LeaseFinance lease simply refers to a method of providing finance in which the leasing company purchases the asset on behalf of the user and rents it to him for a set period of time. The leasing company is referred to as the lessor, and the user is referred to as the lessee.read more if any of the following criteria provided below are met:

  • There is an option to buy the leased asset; or
  • The 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 asset’s fair value at the start of the lease.

What Is an Operating Lease?

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

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

  • 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 leaseAccounted For A Capital LeaseCapital lease accounting adheres to the principle of substance over form, with assets recorded in the lessee's books as fixed assets. Over the term of the agreement, depreciation is charged on the asset as usual. Lease rent is divided into principal and interest and charged to the profit and loss account.read more.

Capital Lease Vs Operating Lease Infographics

The differences between the two concepts of operating lease vs capital lease are explained in the form of infographics below. This will make the topics easy to understand and remember. Let us go through the details below.

Capital Lease Vs Operating Lease Infographics

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Analyst’s Perspective

The capital lease vs operating lease accounting concept can be understand from the example and explanation given below.

Classification of Leases

A piece of equipment with a market price (FMV) of US$100,000 and a useful life of 5 years is leased to a lessee for four years. The lease paymentsThe Lease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration.read more 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.

capital-lease-vs-operating-lease-example

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

capital-lease-vs-operating-lease-test-1-and-2

Test 1 and Test 2 resulted in Operating Lease

capital-lease-vs-operating-lease-test-3

Test 3 implies it is Capital LeaseCapital LeaseA capital lease is a legal agreement of any business equipment or property equivalent or sale of an asset by one party (lesser) to another (lessee). The lesser agrees to transfer the ownership rights to the lessee once the lease period is completed, and it is generally non-cancellable and long-term in nature.read more.

capital-lease-vs-operating-lease-test-4

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 (FMV) of US$100,000 and a useful life of 5 years is leased to a lessee for four years. The lease paymentsThe Lease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration.read more 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 the 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 increase by the present value of lease payments at the inception
capital-lease-part-1

Balance Sheet Effect as the payments are made as per below

capital-lease-balance-sheet-impact-part-2

Book Value of AssetsBook Value Of AssetsBook Value of Assets is the asset's value in the books of records of a company or an institution at any given instance. Assets Book Value Formula = Total Value of an Asset – Depreciation – Other Expenses Directly Related to it read more at the end of each year.

Book Value of Asset (CL Calculation)

Please note that the following –

Income Statement Effect

Income Statement Effect
Income Statement Impact

Cash Flow Effect

Cash Flow Impact

Thus, the above examples give us a clear idea about the capital lease vs operating lease accounting process in any organization.

Key Differences

Some key differences of the two topics have been highlighted below for better understanding.

The above details explaines the capital lease vs operating lease for tax purposes. It clarifies the tax implication of both the cases in a business and how they are accounted for in a transparent manner.

Comparative Table

In the comparative table given below, the important differences have been highlighted clearly based on each individual criteria of differentiation, for capital lease vs operating lease for tax purposes or otherwise, for easy interpretation.

Criteria/ItemCapital LeaseOperating Lease
NatureIt is an alternative to buying the PPE using debt-financingIt is an alternative to renting the PPE for a fixed rental payment.
Impact on the Income statementDepreciation 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 the Balance sheetThe PV of the lease payments or the fair value of the PPE is 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 statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more
  • 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 by debt financing, and the principal repayments made for the debt used to finance the lease.Interest on financing reduces the 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 financingAs 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 a lack of efficiency or lower solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read more.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 obsolescenceAt 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 classificationUS 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:

 

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 risks 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

Capital Lease vs. Operating Lease Video

 

 

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Comments

  1. Stephen Warner says

    First I want to thank you for giving a brief knowledge on Lease, I had little knowledge about the capital lease and operating lease but by going through your article I got a clear explanation on these two. Thanks a lot.