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’.

Lessees and Operating Leases – A company may be incented to treat leases as operating leases because the financial commitment associated with the operating lease contract is not recorded on the balance sheet as a liability.  Operating leases can be seen as a form of off-balance sheet financing for a company.  If a lease is capitalized by a lessee, the resulting liability will have debt-like impacts on a company’s financial ratios.

Lessors and Capital Leases – Companies who act as lessors may be incented to treat leases as sales-type capital leases in order to show higher net income.