Accounting 101: Operating vs. Capital Lease

Posted by Glenn Philips on January 20th, 2021

Whether it’s a property matter or commercial assets; accounting strikes into every scenario. Companies and individuals lease assets for different periods: short-term and long-term. A lease is an agreement allowing the right to utilize property, plant, and equipment for a specific period of time. The time period depends upon the requirement of the lessor and permission of the lessee. Here, the lessee refers to the one who owns the asset and lessor loans or rents the asset for a certain period of time.

Before jumping into leases, know that there are two kinds of methods for leases: operating and capital lease. While we’re at it, let’s figure out the differences between the two.

Operating Lease

An operating lease is considered like credit or renting payments that link to operational expenses. Here, the asset which is leased isn’t included in the balance sheet. This type of lease is put to use when someone wants to lease assets for the short-term which is similar to renting (no transfer of ownership). Moreover, they are included in the expenditure section of the income statement ultimately impacting the operating and net income. So, the accounting treatment for the same is direct and straightforward.

Advantages of Operating Lease:

• Operating lease payments are entitled to tax-deduction.
• Companies are provided with expanded freedom to replace or update their rented asset or equipment whenever they want to.
• As no ownership is transferred, the risk of discontinuance is scrapped.
• The all-in-all accounting process for operating lease is simpler.

Capital Lease

A capital lease is similar to a loan, as we call it. Unlike the operating lease, in a capital lease, the lessee is considered as the owner of the asset so it remains on the balance sheet. Simply, a capital lease is equivalent to being a debt. Also, the value of the asset depreciates over time and this lease incurs interest payment.

Advantages of Capital Lease:

• Capital leases estimate the expenses faster than operating leases. So, a lessee can claim the depreciated value of the asset every year.
• The interest generated can be deducted as an operational expense (taxable income).

In general, operating and capital lease receive different account treatment with respect to the lessor and the lessee. Both have different implications with respect to accounting treatment, ownership, and claims. If you’re planning on leasing any property, plant, or equipment, consult reputed and reliable financial advisors and lenders to leave the dealing in safe hands. Also, now that you’re familiar with the primary distinction between operating and capital lease, determine your requirements and sign up for any asset that you need according to time, budget, interest rate, and many other factors.