Capital leases vs. operating leases

In a capital lease, the lessee is considered to own the leased asset, and is financing it with a loan from the lessor. Based on this ownership designation, the lessee accounts for a capital lease in the following manner:

  • The lessee records the leased asset as a fixed asset
  • The lessee records depreciation expense for the leased asset (usually over the lease term)
  • The lessee records a liability for the present value of the leased asset, using a discount rate that is the lower of the lessor's implied rate or the lessee's incremental borrowing rate
  • As lease payments are made, the lessee records each payment as a combination of interest expense and a reduction of the liability just noted

In an operating lease, the lessor is considered to own the leased asset, and the lessee rents the asset. Based on this ownership designation, the lessee accounts for an operating lease in the following manner:

  • The lessee records each lease payment as an operating expense

Because of the different accounting used for each type of lease, the following differences between the two are apparent:

  • A capital lease results in a fixed asset being recorded on the balance sheet. No asset is recorded for an operating lease.
  • A capital lease results in a depreciation expense being charged on the income statement. No depreciation is charged for an operating lease.
  • An operating lease results in a lease expense being charged on the income statement. There is no such charge for a capital lease, where the expense is instead split between depreciation expense and interest expense.
  • A capital lease results in a liability for the present value of total lease payments being recorded on the balance sheet. No liability is recorded for an operating lease, other than for the current lease payment.
  • An operating lease results in all payments flowing through the operating activities section of the statement of cash flows. For a capital lease, the interest portion of each payment appears in the operating activities section, while the principal portion of each payment appears in the financing activities section.

Related Courses

Accounting for Leases