Capital Lease vs. Operating Lease: What’s the Difference

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A lease is a contract in which the owner of an asset or property allows another party to use the assets or property in exchange for something else, which is generally money or other assets. In accounting, the common types of leases are operating lease and capital lease, also known as a finance lease. 

Generally, as far as accounting is concerned, a capital lease or finance lease is considered an asset when a company prepares the balance sheet. On the other hand, an operating lease is an expense that is not included or recorded in the balance sheet. Thus, both types of leases are used for different purposes and show up differently on the accounting books. 

Capital Leases

A capital lease, for accounting purposes, is treated as a loan for the person who is offering the lease, whereas it’s considered a purchase for the one leasing. Any capital lease agreement terms clearly show that the ownership and resulting benefits and risks are transferred to the lessee. 

One of the features of a capital lease is the transfer of asset ownership when the term ends. Additionally, an option is available to purchase the asset at a discounted rate, a lower price than the original, when the term ends. Moreover, the lease term equals or exceeds 75% of the asset’s estimated useful life. Also, another criterion that classifies them as a capital lease is that the present value of the lease payments is greater than or equal to 90% of the asset’s fair market value.

Capital leases are counted as debts of the lessee. These leases are used for long-term leases and for items that don’t become outdated. As capital leases give ownership to lessees, they are regarded as assets that may depreciate.

Operating Leases

Operating leases, also called service leases, are used for assets that are destined to change. Some examples include computers and office equipment. These leases are used for short-term leasing, which is generally less than a year. The cost related to capital lease is known as operating expense. The significant difference when compared to capital leases, is that operating leases can be used as an asset by the lessee, but the lessor remains the owner. 

New Lease Accounting Standards 

The Financial Accounting Standards Board (FASB) issued new lease accounting standards and how to account for capital lease and operating lease. It has now made it mandatory for all leases of more than 12 months to be recorded as assets and liabilities on the balance sheet. This means that operating leases that are longer than a year must be treated as buying an asset. The changes in lease accounting standards have affected all businesses. The leaders and account managers need to be careful in adding all such operating leases to the balance sheet. 

Consequently, businesses are using lease accounting software to avoid manual errors, creating a single repository for gathering all lease-related data, and creating reports. Lease management software helps in making the process hassle-free as well. 

Yardi Corom is one the best lease accounting and management software solutions that helps in complying with new lease accounting standards. For booking a free demo, click here.