Definition
A capital lease, also known as a finance lease, is a long-term lease agreement that essentially provides the lessee with benefits and risks of asset ownership, making the lease appear as an asset and liability on their balance sheet. An operating lease, on the other hand, is a short-term lease agreement where the lessor retains the risks and benefits of asset ownership. In the lessee’s financial statements, operating lease expenses appear as operating expenses, and the leased asset is not reported on their balance sheet.
Key Takeaways
- A key difference between a capital lease and an operating lease lies in who assumes the risk and rewards of ownership of the asset. In a capital lease, the lessee assumes the risks and rewards, while in an operating lease, the lessor retains them.
- In terms of financial reporting, a capital lease is recorded as both an asset and a liability on the lessee’s balance sheet, which can affect the company’s debt-equity ratio and potentially its ability to secure other forms of financing. On the other hand, an operating lease is not reflected on the balance sheet, only impacting the income statement as a lease expense.
- From a tax perspective, capital leases can offer advantages in the form of depreciation, which can be claimed by the lessee. However, under an operating lease, the lessor retains the right to claim depreciation, leaving the lessee to only claim the lease payments as deductions.
Importance
The financial term “Capital Lease vs Operating Lease” is essential because it refers to two different methods that businesses use to acquire assets. In a Capital Lease, the lessee assumes all the benefits and risks of ownership, and the leased asset is accounted for as if it’s a purchased asset, which is typically depreciated over its useful life and also includes interest expense.
This lease is more like an arrangement of asset financing. Conversely, an Operating Lease does not transfer the risks and rewards of ownership, and the lessor retains ownership while the lessee simply uses the asset in exchange for lease payments.
The lessee typically can deduct these lease payments fully. This classification impacts the financial statement presentation, taxation, and the company’s leverage ratios, thus influencing the financial analysis and decision-making process.
Therefore, understanding the differences between a capital lease and an operating lease is crucial.
Explanation
A Capital Lease, also known as a finance lease, is primarily used when a business intends to use an asset for the majority, if not all, of its useful life. Businesses often choose this lease agreement because it comes with advantages similar to owning an asset, such as the ability to depreciate the asset on the balance sheet. It can be thought of as a form of long-term, non-cancelable lease.
Capital leases are also frequently used for high-cost assets, where the lessor gets their return on the investment mainly through the lease payments, and at the end of the lease term, the lessee may purchase the asset at a reduced price. On the other hand, an Operating Lease is preferred when a business does not want to commit to a long-term agreement and wants the flexibility to change assets or equipment frequently. Businesses can use an asset for a short time without the responsibility of ownership or bearing the risk of depreciation.
They can also easily replace old or obsolete technology without hassle. This type of lease is more like a rental agreement; it is typically short-term, cancelable, and may come with maintenance and repair services from the lessor. Operating leases are often used for assets which have a high risk of becoming outdated, like computers, office equipment, or vehicles.
The main advantage here is the immediate cost-saving, as the lessee is not burdened with the full price of the asset, and the expense can be treated as operational costs which can be deducted from earnings before tax, thus reducing tax liability.
Examples of Capital Lease vs Operating Lease
Automobile Leasing: When a car leasing company leases a car to a driver for a short term (typically 2-to-3 years), this is an example of an operating lease. The leasing company retains ownership and the maintenance responsibilities associated with the car. At the end of the lease, the driver can simply return the car and lease a new one. In contrast, under a capital lease, sometimes offered by car dealerships, the lessee might have the option to purchase the car (for a pre-agreed price) at the end of the lease term, indicating a transfer of ownership.
Commercial Real Estate: When a restaurant operator leases a building for their business, if the lease agreement is set for a long period of time and contains a buyout option toward the end of the lease, it would be an example of a capital lease. On the other hand, if they lease the building just for a few years with no transfer of ownership intended, it would be an example of an operating lease.
Machinery and Equipment Leasing: For example, a construction company may lease heavy machinery for a particular project for a short duration under an operating lease where the leasing company maintains ownership and is responsible for maintenance. Alternatively, if the same company agrees to a lease where they take on responsibilities of maintenance and have an option to purchase the machinery at the end of the lease term, it would be considered a capital lease.
FAQ: Capital Lease vs Operating Lease
What is a Capital Lease?
A capital lease, also known as a finance lease, is a lease agreement that gives the lessee (the person leasing) the benefits and drawbacks of ownership. The lessee can record the leased asset as their own in the balance sheet, which comes with depreciation and interest expense benefits.
What is an Operating Lease?
An operating lease is a lease contract allowing the use of an asset but the lessee does not have the rights of ownership. The leased asset remains in the balance sheet of the lessor, and the lessee only records the lease payments as an expense in their income statement.
What are the key differences between a Capital Lease and an Operating Lease?
The key difference between a capital lease and an operating lease involves the party who assumes the risk of ownership. Under a capital lease, the lessee assumes the risk of ownership, while in an operating lease, the lessor retains the risks and benefits of ownership.
What are some advantages of a Capital Lease?
Advantages of a Capital Lease include the ability to depreciate the asset, potential tax benefits, and the ability to purchase the asset at a reduced price at the end of the lease term.
What are some advantages of an Operating Lease?
The benefits of an Operating Lease include lower payments due to the residual value the lessor will recover at the end of the lease, the flexibility to return the asset at the end of the lease term, and the benefit of updating to new assets more frequently.
How to determine whether a lease is a Capital Lease or an Operating Lease?
A lease is generally considered a capital lease when it meets any one of the following conditions: the lease transfers the ownership of the property by the end of the lease term; there is an option for the lessee to purchase the property at a bargain; the lease term is at least 75% of the life of the asset; or the present value of the lease payments is at least 90% of the asset’s market value.
Related Entrepreneurship Terms
- Lease term
- Residual value
- Lease payments
- Ownership transfer
- Depreciation
Sources for More Information
- Investopedia: An extensive financial and investing education website with articles, dictionary, and tutorials.
- Accounting Tools: Provides comprehensive resources on accounting topics, notably on capital and operating leases.
- Corporate Finance Institute: Offers a wealth of online courses and educational material on finance-related topics.
- The Balance: A site that breaks down complex finance topics into simple, understandable information.
