Capital Lease vs Operating Lease
The former is a non-cancellable contract where both parties should strictly follow its terms, conditions, and rules. In contrast, the latter can be canceled anytime if either party does not follow its terms and conditions/rules.
What is Capital Lease vs. Operating Lease?
A capital lease is a non-cancellable contract, and therefore, both parties should strictly follow its terms, conditions, and rules. In contrast, an operating lease contract can be canceled any time if either party does not follow its terms and conditions/rules.
A lease is a contract between the lessor and the lessee under which the lessee can use the lessor's asset/property for a particular time frame and is mandated to pay rent to the lessor for using the asset/property.
The lease agreement contains the following points:
- Lease term and payment frequency
- Amount of lease
- Amount of deposit
- Renewal option
The lease term can be short, medium, or long, embedded with or without a renewal option. The lease amount is also called rent for using the lessor's asset for a specific term and is the lessee's obligation.
The deposit amount is needed for safety purposes in case the lessee fails to pay rent for any period; the same amount of rent can be deducted from the deposit posted by the lessee.
If the lessor's asset gets damaged in the course of the agreement by the lessee, then the relevant amount is subtracted from the lessee's deposit amount. The different types of leases are:
1. Capital lease
In a capital lease, the lessee can buy the lessor’s asset at lease termination at a discount and take ownership of the asset, and the lessor is required to transfer his asset and get the asset’s negotiated selling price from the lessee in this case.
Capital leases have intermediate to longer-term duration. It is a type of loan contract, and therefore capital lease liability is considered long-term debt for the lessee.
2. Operating lease
In an operating lease, assets are not transferred, and the lessor retains ownership of the asset.
The lessee uses the lessor’s asset for rent payment for a specified term, and upon the termination of a lease, a deposit is returned by a lessor to the lessee. These have shorter to intermediate-term duration. An operating lease is a type of rental agreement.
Key Takeaways
- A capital lease (or finance lease) is a lease in which the lessee effectively gains ownership of the asset, while an operating lease is a lease in which the lessee uses the asset temporarily without gaining ownership.
- Accounting treatment of Capital Lease: The leased asset and corresponding liability are recorded on the lessee’s balance sheet. The asset is depreciated over its useful life, and lease payments are split into interest expense and principal repayment.
- Accounting treatment of Operating Lease: Lease payments are recorded as operating expenses on the income statement, and the leased asset does not appear on the balance sheet.
- Tax Implications on Capital Leases: Lessees can claim depreciation and interest expense deductions, potentially offering tax benefits. For operating leases, lease payments are fully deductible as operating expenses.
How to Recognize a Capital Lease and Operating Lease
In order to classify a lease as a capital lease or operating lease, specific criteria should be met.
A capital lease should meet the following criteria:
- Ownership of the asset can be transferred to the lessee at the end of the lease term.
- Lessee can buy the asset at a discount, at a price less than the asset’s market value, at lease termination.
- The lease term should cover a major part of the asset's economic life, either close to or exceeding 75% of the asset's useful life.
- The present value of lease payments should be at least 90% of the asset’s fair value.
The operating lease should meet the following criteria:
- The asset belongs to the lessor during and after the lease term. Asset ownership is non-transferable.
- There is no bargain purchase option for the lessee.
- The lease term is typically shorter and doesn't cover a significant portion of the asset's life; it should be less than 75% of the asset’s useful life.
- The present value of lease payments should be less than 90% of the asset's fair value.
Capital Lease Vs. Operating Lease Example
Let’s go through an example of a capital lease: PQR is the lessee, and ABC is the lessor. The lease agreement is signed between them. Asset ownership can be transferred at the end of the lease term to PQR.
The asset’s useful life is 10 years, and the lease term is 8 years. PQR can buy the asset at lease termination at a discount to the asset's market value.
The asset's market value is $5,675,000, and PQR can buy the asset for a $ 5,000 discount, which is
($5,675,000 - $5,000) $5,670,000.
Now, let’s see an example of an operating lease: Beta is the lessee, and XYZ is the lessor. They sign a lease agreement. During and after the 3-year lease term, XYZ owns the assets.
The asset’s useful life is 10 years. There is no bargain purchase option available to beta.
Asset’s fair value = INR 2,000,000, and Beta is required to pay a lease of INR 50,000
(2,000,000 * 0.0250) every month
Note
0.0250 is used because rent value is 2.5% of the asset’s fair value in India.
Impact of Capital Lease and Operating Lease on Financial Statements
A capital lease is capitalized on the balance sheet by the present value of future lease payments. The lessee records this as a liability, whereas the lessor records this as a fixed asset on the balance sheet.
A capital lease is recorded on the balance sheet. The lessee will record this as a balance sheet liability, whereas the lessor will record this as a balance sheet asset.
Depreciation and interest expense associated with the asset are recognized in the income statement by the lessor. If the lessor buys the asset on a loan, then the lessor must pay interest expenses.
Depreciation and interest expense are recorded in the income statement as expenses by the lessor. These expenses will reduce the lessor’s net income/profit.
Let us take an example: A loan of $4,000,000 is obtained on the property by the lessor with an interest rate of 5% for 10 years. Therefore,
Interest Expense = $4,000,000 * 0.05 * 10 = $2,000,000
The asset is depreciated over its useful life of 18 years using the straight-line depreciation method with:
- Asset Value = $13.500,000
- Salvage Value = 0
Therefore,
Depreciation Expense = $13,500,000/ 18 = $750,000
| Income statement Expense | Amount in USD |
|---|---|
| Depreciation expense | $750,000 |
| Interest expense | $2,000,000 |
The present value of lease payments is calculated by discounting future lease payments at an appropriate discount rate. This discount rate impacts the lessee's capital lease liability and the lessor's fixed asset.
- If a higher discount rate is used, the lessee's capital lease liability will decrease, and the lessor's fixed assets will decrease as well.
- If a lower discount rate is used, the lessee's capital lease liability will increase, and the lessor's fixed assets will also increase.
Higher discount rates are associated with high risk. An asset is considered risky if it has lower credit quality.
Lower discount rates are associated with low risk of an asset. An asset is considered less risky if it is in good condition, not heavily used, and has an increasingly high value.
Note
Higher depreciation expense and higher interest expense will reduce the income and profitability of the lessor. To pay off interest expenses, the lessor should demand lease payments that are greater than or equal to the interest expenses that the lessor is required to make.
The lessor should assess the lessee's creditworthiness before signing the lease agreement.
Creditworthiness can be assessed based on assessing the financial statements of the lessee and checking the lessee's debt payment history to know whether the lessee was able to make debt payments regularly or defaulted on some payments.
The lessor can calculate the probability of default or losses to assess how much risk the lessor is taking by entering into the lease agreement.
If the probability of the lessee failing to meet the required payments is high, then the lessor can demand higher cash flows that are high in future lease payments. This would increase the capital lease liability of the lessee.
The capital lease liability is considered a long-term liability/debt. Therefore, increasing capital lease liability would increase all debt-related ratios and adversely impact the lessee.
The lessee records the operating lease as a debt liability on the balance sheet. The lessee is required to make rent payments, which reduce the income statement by the rent expenses paid over the lease term.
Note
Operating leases are off the balance sheet, but there are increasing standards to make this on the balance sheet item.
The lessee should have sufficient liquidity to meet operating lease liability and pay for rent. The lessor can charge higher rent amounts to the lessee who defaults on making payments.
The higher the rent amount, the higher the operating lease liability for the lessee, and more debt will be shown on the balance sheet, which negatively impacts the business.
Calculating Capital Lease Liability and Operating Lease Liability
Capital lease liability is the present value of future lease payments.
Lease payment year 1 / (1 + DR)1 + Lease payment year 2 / (1 + DR)2 + ... + Lease payment year N / (1 + DR)N
Where
- N = Lease term
- DR = Discount rate
Let’s go through an example:
- Discount rate = 10%
- N = 3 years
- Lease payment = $10,000
Derivation of capital lease liability:
Capital lease liability = Lease payment/ (1 + DR)1 + Lease payment/ (1 + DR)2 + Lease payment/ (1 + DR)3
= $10,000/ (1.10)1 + $10,000/ (1.10)2 + $10,000/ (1.10)3
= $9,091 + $8,264 + $7,513 = $24,868
Operating lease liability is the present value of future rent payments.
Operating lease liability = Rent in year 1 / (1 + DR)1 + Rent in year 2 / (1 + DR)2 + ... + Rent in year N / (1 + DR)N
Where
- DR = Discount rate
Let’s go through another example:
- Discount Rate = 8%
- N = 2 years
- Rent = $5,000
Now, let us calculate the operating lease liability:
| Year | Rent | Discounting factor at 8% | Present value of rent = Rent * Discounting factor |
|---|---|---|---|
| 1 | $5000 | 0.9259 | $4630 |
| 2 | $5000 | 0.8573 | $4287 |
Discounting factor = 1/(1 + Discount rate)Year
Operating lease liability = Sum of the present value of rent payments
= $4,630 + $4,287 = $8,917
Risk and Rewards Associated with the Asset
Some examples of risks and rewards that are associated with the asset are listed below.
These risks/rewards are either borne by the lessee or the be with the lessor.
| Examples of risks | Examples of rewards |
|---|---|
| Decrease in value of the asset | Increase in value of the asset. |
| Decrease in cash flows related to the asset. | Increase in cash flows related to the asset. |
| Negative changes in factors that drive asset value, cash flows, and return. | Positive changes in factors that drive asset value, cash flows, and return. |
| Structural damages to the asset. | Improvement in the quality of the asset. |
| Asset considered illiquid and therefore has high transaction cost and difficulty buying or selling that asset. | Asset considered liquid and has low transaction cost, and buying or selling the asset is easy. |
Risks and rewards associated with the asset be with the lessor in case of an operating lease. The lessee is required to pay rent to the lessor and does not participate in the asset’s value appreciation nor take risks that occur with the asset.
Risks and rewards associated with the asset be with the lessee in case of a capital lease. Lessee is required to make lease payments, take all benefits, and bear any risks with the asset.
Cancellable Vs. Non-Cancellable Contract
Cancellation refers to terminating the lease contract in the middle of the lease term. This can be done either by the lessor or the lessee.
The contract can be terminated for several reasons:
The lessee defaults on lease/rent payments frequently, forcing the lessor to terminate the lease contract before the expiration of the lease term.
Either the lessee or the lessor not following the terms and conditions and rules mentioned in the lease contract would lead to before the due date termination of the lease.
The lessor finds another more creditworthy lessee or wants to use the asset himself and therefore needs to terminate the lease contract before the lease term.
The lessor wishes to sell the asset and hence terminate the contract in the middle.
Note
Before canceling any lease contract, the respective party who wishes to leave and terminate the contract before the maturity of the lease term should give prior written notice to the other party. This notice is to be sent in a given notice period, for example, 30 days before canceling the contract.
A capital lease is a non-cancellable contract, and therefore, all the terms and conditions, and rules should be followed strictly by both parties.
An operating lease contract can be canceled anytime if any of the parties does not follow contract terms and conditions/rules.
Prior notice before terminating the contract is required. If any party fails to give this notice, the other party will end up paying the penalty.
Capital Lease Vs. Operating Lease FAQs
If operating lease liability is off the balance sheet (not mentioned in the liability section of the balance sheet), then it will reduce total balance sheet liabilities.
An addition in rent expenditure will reduce the lessee's profit and profit margin and increase rental income for the lessor; therefore, the lessor’s net income and net profit margin will increase.
A decrease in rent expense will increase the lessee's net profit and net profit margin. A decrease in rent expense means the lessor will receive less rent as income; therefore, the lessor’s net profit and net profit margin will decrease.
A reduction in capital lease liability has a good impact on the lessee, whereas a reduction in capital lease liability has a bad impact on the lessor.
An addition in capital lease liability has a bad impact on the lessee, whereas an addition in capital lease liability has a good impact on the lessor.
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