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Differences Between Operating Lease And Capital Lease:

In simple words, a lease can be defined as an agreement that states the right to use a plant, property, or machinery for a given period. The party which secures the right to use an asset is a lessee whereas, the one who owns it is known as the lessor.

It must be noted that there are several types of leases available in the market today, including capital lease and operating lease. While both are quite popular among business owners, one must make it a point to find out the features and benefits of each of these leases. For instance, at KredX, businesses can use their rental agreements and leases to gain access to growth capital and boost their operations.

Table Of Contents :

1) What Is Operating Lease?

2) What Is Capital Lease?

3) Differences Between Operating Lease And Capital Lease

Being familiar with the pros and cons of each such lease, helps to determine which of them is more suitable for a business at a given point of time. To gain a fair idea about it, companies should look at these pointers that elucidate operating lease vs capital lease, to make a more informed decision. 

What Is Operating Lease?

Typically, an operating lease can be defined as a contract that permits an asset to be used under pre-defined terms. However, such an agreement does not give the business entity any ownership right. 

An operating lease is a type of off-balance-sheet financing. It means that a leased asset’s accompanying liabilities, like rent pay-outs, are not included on the firm’s balance sheet.

Any lease that does not meet any of these 4 criteria, is treated as an operating lease –

  1. Transfer of ownership.
  2. Availability of bargain option.
  3. The lease term is more than 75% of the asset’s economic life. 
  4. The present value of lease pay-out should be at least 90% of the market value.

What Is Capital Lease?

This is a rental agreement that allows a renter to use an asset owned by another individual, for a specific period and as per pre-determined terms. Notably, such a lease manifests characteristics of ownership of assets, especially for requirements related to accounts. 

A capital lease is also known as a financial lease. This lease requires the lessee to record underlying assets as their own. 

Typically, to qualify as this rental lease, a contract must meet any of these criteria –

  • The lease’s lifespan must be at least 75% or more than the asset’s productive life.
  • It must accompany an option to bargain purchase.
  • The lessee gains ownership of the asset when the lease period ends. 
  • The lease payment’s immediate value must be at least 90% of the market value of said asset.

Differences Between Operating Lease And Capital Lease:

All fundamental differences between an operating lease and capital lease, root from their disparity in accounting and structure. 

On that note, glance through this table below which highlights some noteworthy differences between operating lease and capital lease. Doing so will help in gaining a detailed insight into the difference between operating lease and capital lease –

Parameter

Operating Lease

Capital Lease

Purpose

Operating lease is an alternative to renting PP&E against a fixed rental pay-out.

A capital lease is an alternative means of purchasing PP&E on debt financing.

Ownership 

Lessor retains ownership of assets in question even after the end of the lease term. 

The ownership of leased assets may be transferred to the lessee when the term ends. 

Term of lease 

Its term is usually less than 75% of the economic life of the machinery. Typically, it is active for the short term.

The term usually equals or is more than 75% of the asset’s shelf life. It is active for the long term.

Accounting treatment

In accounts, payments are considered as operating expenses. As a result, it is shown in the Profit and Loss Statement.

Leased assets are recorded as assets, while the lease payments are recorded as a liability. Also, the payments are recorded in the balance sheet.

Depreciation

An operating lease does not depreciate.

A capital lease depreciates with time.

Tax benefit

Lease pay-outs are treated as a rental expense. 

A lessee can claim depreciation expense along with interest expense as they are considered to be the equipment’s owner.

Bargain purchase option

The bargain purchase price is not available.

The bargain purchase option is available.

Transferability 

The associated risk and reward tend to remain with lessors. 

The risk and reward get transferred to lessees.

Risk burden 

The risks and benefits remain with lessors. Also, lessees have to pay the maintenance cost.

Lessee has to pay the maintenance, tax, and insurance charge. 

KredX’s lease rental discounting facility enables companies to get the capital tied up in rental agreements or leases, thereby providing upfront funds for growth and expansion. 

Notably, businesses must also give due attention to the accompanying terms of service and liabilities, when it comes to operating lease vs capital lease. Doing so will help them to gain a better idea about all intricacies related to both the options.