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Capital Lease vs. Operating Lease: What’s the Difference?

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Equipment leasing is a common alternative to purchasing assets upfront. Instead of buying expensive equipment for your business, you essentially would be paying rent to use the tools for a certain amount of time.

In general, a lease would allow you to finance the full cost of equipment without making a down payment. The leased equipment would act as collateral to secure the funding, and the lessor would typically retain the legal title of the equipment while you make payments to use it. You could have the option to purchase the equipment at the end of the lease term, or you could return the assets.

When choosing this financing option, you may be able to select a capital lease or an operating lease. The type of lease you pick would impact how you record the expense on your financial statements. We’ll discuss the differences between a capital lease and an operating lease, and which may be the better choice for your business.

What is a capital lease?

A capital lease, or a finance lease, must meet criteria based on national accounting standards. To be considered a capital lease, the lease must meet one of four conditions:

  • One of those conditions is that the lease includes the option to transfer ownership at the end of the term. Because you could own the equipment when the lease is up, a capital lease would be considered a form of debt financing, like a loan.
  • Another condition is that after making lease payments for a set amount of time, you would be able to purchase the equipment for a discounted price.
  • The third condition is that the term length of a capital lease must last at least 75% of the useful life of the asset.
  • And the fourth is that the value of your lease payments would have to equal at least 90% of the equipment’s fair market value.

If the lease meets any one of those conditions, it could be classified as a capital lease.

Because a capital lease is considered debt financing, you would have to expense interest payments and depreciation on your income statement. You would also need to record the present market value of the equipment on your balance sheet, which would reflect the current value of the equipment.

The advantages of a capital lease include the ability to claim depreciation on your equipment, which would reduce your taxable income. Interest expenses would also reduce your taxable income. A capital lease may be an attractive option if your business is in a higher tax bracket.

What is an operating lease?

Operating leases are commonly used for short-term assets and don’t include the transfer of ownership at the end of the term. It’s comparable to renting. Lease payments are considered operating expenses and would be expensed on your income statement.

You would have unrestricted use of the equipment during your lease period. However, you would be responsible for the condition of the equipment when you return it at the end of your term. Because you would return the asset, an operating lease would be useful for equipment that you plan to replace quickly or at regular intervals.

Business owners were previously able to disregard an operating lease when creating their balance sheet because of the lack of ownership rights. Recent changes from the Financial Accounting Standards Board now require business owners to account for an operating lease on their balance sheet, similar to a capital lease. Balance sheets must reflect the equipment under an operating lease as a fixed asset based on the present value of the remaining lease payments.

The new standard is now in effect for public companies and will take effect for private companies after Dec. 15, 2019. The FASB made the change with the intention of helping investors and other users of financial statements, like accountants, more accurately understand how a company’s lease transactions affect assets and liabilities.

Although an operating lease would appear on your balance sheet, it would not be considered debt as a capital lease would. Instead, it would be classified as a non-debt operating liability, which would prevent an impact on your credit rating.

Capital lease vs. operating lease: How they differ

New guidance from the FASB requires business owners to disclose both capital lease and operating lease liabilities on balance sheets, eliminating one of the main differences between the two financing agreements. However, there are a few other distinctions to consider when choosing between an operating lease and capital lease.

Ownership: Capital leases provide a pathway to ownership. At the end of the lease term, ownership rights would be passed to you or you’d have the option to purchase the asset at a discounted price. Throughout the term of an operating lease, the lessor maintains ownership rights. If you want to continue using the equipment when the term ends, you’d have to sign another lease.

Lease length: An operating lease term is typically one year or less in length. Capital lease terms must be at least 75% of the useful life of the asset. If an asset does not have a long useful life, an operating lease would be the better financing option.

Balance sheet impact: All lease liabilities would have to go on your balance sheet, but an operating lease would have less impact on your overall return on assets (ROA). Only the present value of remaining lease payments would need to be disclosed on the balance sheet for operating leases, while capital leases would require you to include the present value of the full asset. Operating leases would typically show a lower amount and wouldn’t lessen your ROA as much as a capital lease could.

How leases and loans compare

When shopping for equipment financing, you might be considering both leases and loans. Like a capital lease, an equipment loan would give you ownership of the assets after you pay back your debt. However, a loan would require a 10% to 20% down payment, whereas a lease would not.

An equipment lease usually requires lower monthly payments than a loan, but leases often have higher interest rates, making them more expensive in the end. Repayment terms can be more flexible for leases than loans, which would be ideal if your equipment won’t last long.

Your credit history could also influence your choice of a lease or a loan. You may need a strong credit profile to qualify for an equipment loan. Credit requirements are typically more lenient for equipment leasing, though a poor credit score could still lessen your chances of being approved.

Choosing the right lease

Deciding between an operating lease and a capital lease would depend on several factors, most notably the amount of time you plan to use the assets that you’re financing and if you want to own those assets in the future.

A capital lease would allow you to own equipment without immediately purchasing it outright. You would make payments for a set period of time, then buy the equipment at a discounted price when your lease term ends. Because a capital lease term may equal at least 75% of the useful life of the asset, this lease option would be better suited for equipment with a long useful life. You wouldn’t want your lease to exceed the life of the equipment.

An operating lease, on the other hand, would be ideal for assets that have a shorter useful life or that you plan to replace often. When the lease is up, you would return the equipment to the lessor.

Both leases would impact your financial statements. In the past, business owners didn’t have to account for an operating lease on their balance sheet. But new accounting guidelines call for both operating lease and capital lease liabilities to be included on a balance sheet.

To make sure you understand the full impact of a capital lease or an operating lease, consider consulting an accountant or financial advisor who could help you determine which lease makes the most sense for your small business.

 

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