Definition of the topic: A capital lease is treated like an asset that remains on a company’s balance sheet, whereas an operating lease remains off the balance sheet. A capital lease is like a loan where the asset is treated like being owned by the lessee while an operating lease is more like renting; hence it is considered an operating expense.
Features or Characteristics of Capital Lease
The qualities of this are listed below:
- It is a contract that entitles the lessee the temporary ownership of the asset.
- The renter needs to book assets and liabilities associated with the lease if the rental contract meets the given requirements.
- Lessee has the economic ownership of asset for accounting purposes.
- The contract gives the lessee option to buy the asset at a discount to the fair market price at the end of the lease term.
Features or characteristics of Operating Lease
- This contract entitles the lessee the right to use the asset.
- It does not give any ownership rights to the lessee.
- Accounting for operating lease is governed by GAAP rules.
- Lease payments are considered operating expenses.
- Assets leased are expensed on the income statement, so they affect both operating and net income.
The lease must meet one of the four criteria:
- Ownership – The asset ownership is transferred from the lessor to the lessee by the end of the lease term.
- Bargain option – The lessee has an option to bargain the price of assets to less than its current market value to buy the asset.
- Lease term – During the lease period, the asset should have at least 75% of its useful life remaining, or the lease is non-cancellable during that period.
- Present value – The present value of the minimum lease payments should be at least 90% of the asset value at the starting of the lease period.
- Operating Lease – If none of the requirements of capital lease met, then the contract is qualified as an operating lease.
Difference between a capital lease and an operating lease
Under the capital lease, the lessee retains the ownership of the asset, while in an operating lease, the lessee is not the owner of the asset.
- Under a capital lease, the lessee pays the maintenance, insurance, and taxes, whereas, under an operating lease, all the expenses remain with the lessor.
- Under a capital lease, the lessee can claim the depreciation, whereas, under the operating lease, the lessee is not concerned with the depreciation.
- Usually, in the capital lease, the present value of lease payments is greater than or equal to 90% of the original cost, whereas in operating, it is generally less than 90% of the asset’s market value.
To conclude, capital and operating leases both have different significance for lessee and lessor. In the case of the capital lease, the lessee owns the assets and can claim depreciation, whereas, under the operating lease, the lessee is not the asset owner and is not concerned with its depreciation.