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.

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.

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.

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 lessee 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 lease 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.

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 lease.

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.

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 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 an Operating Lease. To understand this, we perform the tests to determine the same.

Test 1 and Test 2 resulted 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.

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 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 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

Balance Sheet Effect as the payments are made 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 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

• The total cash payment reduces cash flow from operations in an operating lease.
• 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.

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

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

• The net income will be higher in the operating lease in the initial years because the depreciation and interest expenses will be higher in the finance lease. As the lease comes to an end, the situation will reverse. However, the total Net income over the entire lease period will add up to the same number under both categorizations, as these are only reporting mechanisms.
• EBIT is higher under Capital lease because a part of the lease payment is interest payment. This is reported below the EBIT and on the Income statement; however, the entire lease payment is reported above the EBIT under the Operating lease.
• CFO is higher for capital lease because a portion of the lease that goes towards reducing 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, the entire lease payment reduces the CFO under the Operating Lease, and the tax is higher due to a lack of depreciation expense.
• So naturally, CFF is lower for financial leases and higher for Operating leases; however, the sum of the change in cash remains the same over the entire lease period.

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.

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.

This article is a guide to what is Capital Lease Vs Operating Lease. We explain it with examples, infographics, analysts perspective, key differences. You may also have a look at the following articles –

• Differences Between Finance vs. Lease
• Bank vs. Company Balance Sheet Differences
• FIFO vs. LIFO
• Calendar Year vs. Fiscal Year