Capital Lease: What It Means in Accounting, 4 Criteria

This step-by-step guide covers the basics of lease accounting according to IFRS and US GAAP. The Internal Revenue Service (IRS) may reclassify an operating lease as a capital lease to reject the lease payments as a deduction, thus increasing the company’s taxable income and tax liability. A capital lease is recorded on the balance sheet as a liability similar to a loan, and the interest portion of the payments is tax-deductible. In most cases, you can also take deductions for the annual depreciation of the leased item, thereby saving money on your taxes. With an operating lease, you are renting the asset; you don’t own it and don’t have a purchase option for a bargain price. If the item has maintenance problems, it is the lessor’s responsibility to make the repairs.

Operating leases are assets rented by a business where ownership of the asset is not transferred when the rental period is complete. Typically, assets rented under operating leases include real estate, aircraft, and equipment with long, useful life spans—such as vehicles, office equipment, or industry-specific machinery. The lessee is renting the asset to manage the normal operation of their business. For capital lease vs operating lease tax purposes, operating lease payments are similar to interest payments on debt; these payments are considered operating expenses on the business tax form for the year. The lease liability represents the lessee’s obligation to make lease payments and is calculated as the present value of all known future lease payments. An operating lease is a contract that doesn’t entail any ownership of the asset.

Advantages of an operating lease

Operating leases are like renting and do not transfer ownership of the asset at the end of the contract. Unlike a capital lease, the lessee does not have an option to purchase the asset at the end of the agreement at a bargain price. Leasing is a cost-effective way to acquire the use of a fixed asset without purchasing the asset outright. Not understanding the differences between a capital lease and an operating lease can be costly. In 2016, the Financial Accounting Standards Board (FASB) made an amendment to its accounting rules requiring companies to capitalize all leases with contract terms above one year on their financial statements.

Are you looking for more detail on finance and operating lease accounting under ASC 842? Our Ultimate Lease Accounting Guide includes 44 pages of comprehensive examples, disclosures, and more. Capital lease payments reduce the liability for the lease, and the interest on lease payments is a deductible business expense.

Capital Lease Vs. Operating Lease Example

At the beginning of the lease agreement, the present value of all lease payments will be calculated. A finance lease transfers the asset and any risk or return to the lessee. This means that ownership is transferred in a financial lease to the entity that leases the asset.