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For a lease to be classified as a capital lease in U.S. GAAP, any of the four conditions must be satisfied:
The term of the lease is greater than or equal to 75%of the useful life asset. In our example, tenure is 25 years, and suppose the useful life of the property is 20 years. So, 75% (20) = 15 years, which satisfies the condition so classified as a capital lease.
A transfer of ownership at the end of the tenure.
An option to purchase the asset at a discounted price at the end of the tenure. For IFRS, there are one more criteria to evaluate it as a capital lease.
Only the lessee can utilize the asset without any major changes made in the assets which are under the lease.
Before starting with the differences, just think of a capital lease as owning property and an operating lease as just renting the property. Let us understand the complete difference between the two leases with the same example.Head to Head Comparison Between Capital Lease vs Operating Lease (Infographics)
Below is the Top 7 difference between Capital Lease vs Operating Lease:Key Differences Between Capital Lease vs Operating Lease
Risk and returns related to the asset ownership are transferred to the lessee in a capital lease. In an operating lease, the risk and rewards related to the asset ownership remain with the lessor.
While taking the same example as above, we depreciate the asset in our balance sheet, i.e. the property which we own is depreciated over time. Due to the depreciation of the capital lease, the taxable income reduces. However, renting a property is not depreciated over the period.
The tenure of the capital lease is long-term, whereas it is short-term for the operating lease. So, transfer of ownership is required in the capital lease and not in the operating lease. E.g. Owing a property for a long-time duration, one needs to transfer the ownership rights. In the case of renting, it is for a very short period, and transfer of ownership is not mandatory. The transfer of ownership in an operating lease stays with the lessor for the entire lease period. In the case of the capital lease, the ownership transfer is optional at the end of the tenure period. The title may or may not be transferred to the lessee.
A capital lease doesn’t have flexibility compared to an operating lease. As the accounting treatment is very easy in the operating lease, one can change the asset regularly and update it. In our current example, we have considered renting a property as an operating lease. If we need to change the rental property, the process is very easy as the only expense is involved. In the case of a capital lease, when we own the property, the flexibility of changing the asset decreases drastically.
Transfer of ownership is required in the capital lease and not in the operating lease. E.g. Owing a property is for a long-time duration, one needs to transfer the ownership rights. In the case of renting, it is for a very short period, and transfer of ownership is not mandatory. Due to this, there is a high risk of obsolescence involved in the capital lease. There is no risk of obsolescence involved in the operating lease.
The bargain purchase option is available in the case of the capital lease. In the operating lease, there is no bargain purchase option available.Comparison Table of Capital Lease vs Operating Lease
Below is the topmost comparison between Capital Lease vs Operating Lease.
Basis of Comparison
Definition Risk and reward are transferred to the lessee. Risk and reward remain with the lessor.
Depreciated Yes No
Treatment An asset in the balance sheet Expense in the Income statement
Tenure Long term Short term
Flexibility Less More
Transfer of Ownership Required Not required
Bargain Purchase Option Yes NoExample of Capital Lease and Operating Lease Operating Lease
A company enters into an agreement of 4 years to rent the building. There is no cancellation and renewal policy. The landlord carries out the maintenance. Thus, this lease is classified as an operating lease.Capital Lease
ABC ltd leased out construction equipment from XYZ’s real estate company. The lease period is of 6 years. Considering 10 percent as the rate converting the rate to the Present value. The present value factor for 6 years at 10 percent is 4.355. The payment of the leased payment is 3 lakhs. The Present Value of the minimum leased payment is 4.355*3=13.065 lakhs.Conclusion Recommended Article
This is a guide to the Difference between Capital Lease vs Operating Lease. Here we also discuss the Capital Lease vs Operating Lease key differences with infographics and a comparison table. You may also look at the following articles to learn more-
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