Difference Between Capital and Operating Lease

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.

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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; orThe lease period covers at least seventy-five % of the useful life of the asset; orOwnership of the leased asset shifts to the lessee following the lease expiration; orThe 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 ownershipTest 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

Analyst’s Perspective

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.

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 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.

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 $88,067Both 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 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.

Please note that the following –

  • Depreciation (term of 4 years) = $88,067/4 = $22,017,Principal repayments equal the lease payments LESS interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read moreThe asset is being depreciated at a rateDepreciated At A RateThe depreciation rate is the percent rate at which an asset depreciates during its estimated useful life. It can also be defined as the percentage of a company’s long-term investment in an asset that the firm claims as a tax-deductible expense throughout the asset’s useful life.read more 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 incomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more 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 operationsCash Payment Reduces Cash Flow From OperationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more in an operating lease.In a capital lease, the part of lease payment considered payment on principal reduces cash flow from financing activitiesCash Flow From Financing ActivitiesCash flow from financing activities refers to inflow and the outflow of cash from the financing activities like change in capital from securities like equity or preference shares, issuing debt, debentures or repayment of a debt, payment of dividend or interest on securities.read more.Total CF is unaffected by accounting treatment.

Key Differences

  • 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 statementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more; 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.

Capital Lease vs. Operating Lease Comparative Table

Capital Lease vs. Operating Lease Video

 

This article is a guide to Capital Lease vs. Operating Lease. Here we discuss their top differences and an example and comparative table. You may also have a look at the following articles –

  • 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.

 

  • Sale Type lease, at the end of which the ownership transfers and there is a profit for the Lessor because the PV of the payments is greater than the carrying valueCarrying ValueCarrying value is the book value of assets in a company’s balance sheet, computed as the original cost less accumulated depreciation/impairments. It is calculated for intangible assets as the actual cost less amortization expense/impairments.read more of the Leased PPE Direct Finance Lease is the one in which there is no profit, and the Lessor is only a financer for the Lessee. US GAAP requires that the lease period is at least 75% of the useful life of the PPE. PV of the lease payments is at least 90%  of the fair value of the lease asset. Existence of a bargain purchase option

IFRS mentions a more generic categorization saying that all risk and rewards should be transferred to the Lessee

IFRS mentions a more generic categorization saying that all risks and rewards should not be transferred to the Lessee.

  • Lower Current & Asset turnover Ratios

  • Lower Working capital

  • Lower return on assets and equity

  • Higher debt to equity and asset ratios

  • Higher Current and  Asset turnover RatiosAsset Turnover RatiosThe asset turnover ratio is the ratio of a company’s net sales to total average assets, and it helps determine whether the company generates enough revenue to justify holding a large amount of assets under the company’s balance sheet.read more;

  • Higher Working capital

  • Higher return on assets and equity

  • Lower debt to equity and asset ratios

  • Differences Between Finance vs. LeaseBank vs. Company Balance Sheet DifferencesFIFO vs. LIFOCalendar Year vs. Fiscal Year