What is the Difference Between Operating Lease and Capital Lease?

The main difference between an operating lease and a capital lease (also known as a finance lease) lies in the ownership and accounting treatment of the leased asset. Here are the key differences between the two types of leases:

Operating Lease:

• Treated like renting, with payments considered operational expenses.
• The asset being leased stays off the balance sheet.
• The lessee does not record the leased assets on its balance sheet, as there are no ownership rights.
• Rental expense associated with the lease is recognized on the income statement in the period, and each payment is tracked on the cash flow statement.
• The asset must be returned to the owner at the end of the lease term.

Capital Lease (Finance Lease):

• Resembles a financed purchase, with the lease term spanning most of the asset's useful life.
• The leased asset is treated as an asset on the lessee's balance sheet.
• The lessee is required to record the leased asset on its balance sheet, as they have substantial ownership rights.
• The leased asset is treated for accounting purposes as if it were actually owned by the lessee.

In summary, a capital lease is considered more like a loan, where the asset is treated as being owned by the lessee and stays on the balance sheet, while an operating lease is treated like renting, with payments considered operational expenses and the asset staying off the balance sheet.

Comparative Table: Operating Lease vs Capital Lease

The main differences between operating leases and capital leases are related to their accounting treatment, ownership transfer, and lease term. Here is a summary of the key differences between the two types of leases:

Operating leases are treated like rentals, with payments considered operational expenses and the asset being leased remaining off the balance sheet. In contrast, capital leases are more like loans, with the asset treated as being owned by the lessee and recorded on the balance sheet.

Leases are classified as either operating or capital based on the following criteria:

1. Transfer of ownership
2. Bargain purchase option
3. Lease term greater than or equal to 75% of economic life
4. Present value of payments greater than or equal to 90% of fair market value

Leases that do not meet any of the four criteria are accounted for as operating leases. If all of the criteria are true, it will be accounted for as a capital lease.