Capital Lease vs. Operating Lease

There are two types of accounting methods for leases and they are a capital lease and operating lease. Leasing is different than buying and when you buy a business asset like a vehicle, you are buying an asset. Leasing is when you have an expense to use the asset, but you do not own it. Capital leases are considered the same as a purchase. Operating leases cover the use of vehicle or assets for a certain period of time. In this article we will discuss the difference between capital and operating leases and how your lease terms can impact your business.

What Is a Capital Lease?

Capital leases count as debt and depreciate over time and incur interest expense. The lessee assumes all risks and benefits of asset ownership. The legal owner is the lessor during the term of the contract.

There are 4 conditions that a lease must meet to qualify as a capital lease.

  1. Ownership of the asset transfers to the lessee when the contract ends.
  2. The lessee can purchase the asset at a discount price when the agreement ends.
  3. The lease has a term that is greater than the useful life of the asset.
  4. The present value of the lease payment is equal to the asset’s fair market value.

If these 4 conditions are not met, the lease will be classified as an operating lease. Capital leases are used to lease assets with long-term useful lives that are 5 years or longer. The payments include both principal and interest expenses.

What Is an Operating Lease?

An operating lease is called a service lease sometimes and are used for short-term leasing (less than one year) and are for assets that are high-tech or in which technology changes. The rental cost of an operating lease is an operating expense.

Operating leases do not transfer ownership of the asset when the contract ends. The asset can only be purchased at its fair market value unlike a capital lease. Operating leases have lower monthly payments because you are not financing the entire cost of the asset.

Advantages of a Capital Lease

There are some advantages of a capital lease which are:

  • Being able to use depreciation and interest deductions and have an attractive purchase price at the end of the agreement.
  • Suitable if you need equipment with a long life like tools and machines, not electronics or computer equipment which become obsolete in just a couple years.
  • The lessee can claim depreciation deductions on the income statement to reduce taxable income.

Advantages of an Operating Lease

Some of the advantages of a capital lease are:

  • Used to finance equipment that is needed for a short term or has a history of becoming obsolete.
  • Businesses with operating leases do not want to keep the asset over the long term.
  • Lessees have flexibility to get newer equipment often to keep up with the latest upgrades.
  • Lease payments are treated as expenses and are deductions on the income statement.

Differences Between a Capital Lease and an Operating Lease

The differences between these two types of leases is that if you own the asset when the contract ends, it is a capital lease. The lessee does not take possession of the asset when it is an operating lease.

If you can purchase the items you are leasing it, if there is no purchase option it is an operating lease. If the term lasts for a major part of the assets life it is a capital lease, if it is less than the useful life it is an operating lease.

The Bottom Line

Now that you understand what a capital lease and an operating lease are, you might be wondering which one is better. The answer is that it depends. Capital leases are best for leasing assets for a long time and you are expected to purchase it. Operating leases are for short term commitments. Each type comes with its own advantages so find out which one is going to work out for you.