Capital Leases and Operating Leases

A lease can be an operating lease or a capital lease.

Operating Lease – Typically a short-term lease where the lessor retains most of the benefits and risks associated with owning the asset. In operating lease, no asset and liability are recorded on the lessee’s balance sheet. Lease payments are reported as expense when paid.

Capital Lease – Typically a long-term lease where the lessee assumes most of the benefits and risks associated with owning the asset. In capitalizing a lease, an equal balance sheet asset and liability are created and both are reduced over the term of the lease; these reductions are expensed to the income statement. Note that ‘Capital lease’ is the term used by US GAAP. Under IFRS it is called ‘Finance lease’.