Capital Leases and Operating Leases

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.