Capital Leases vs. Operating Leases: 5 Key Distinctions Under ASC 842
Lease accounting has experienced a major transformation with the implementation of ASC 842, requiring most leases to appear on the balance sheet. Under prior lease accounting guidance, an operating lease was not reflected on the balance sheet and payments were expensed on a straight-line basis. Instead, a capital lease was treated more as a loan, and the asset was reflected on the balance sheet.
Understanding the differences between operating and capital leases is now essential for accurate financial reporting, regulatory compliance, and effective lease management. In this post, we will define both lease types, explore the five key distinctions under ASC 842, and explain what these changes mean for businesses today.
What is an operating lease?
An operating lease is a lease in which the lessor retains ownership of the asset during and after the lease term. Historically, operating leases were not recorded on the balance sheet, and lease payments were treated as rent expense. Most leases fell into this category and were only disclosed in footnotes, making them less visible in financial statements.
What is capital (finance) lease?
A capital lease, also called a finance lease, is treated like a loan, with both the leased asset and liability recorded on the balance sheet. Expenses are recognized as interest and depreciation rather than straight-line rent expense. Under ASC 842, a lease is classified as capital if it meets at least one of the FASB “bright-line” tests, which we’ll explore next.
Key Distinctions Between Operating and Capital Leases
Under ASC 842, here are five distinctions between capital leases and operating leases based on the FASB’s “bright-line” tests (only one has to be met):
Operating lease
Capital lease
The lessor retains ownership during and after the lease term
The lessee may purchase (own) the asset at the end of the lease term (Transfer of Ownership Test)
The lease cannot offer a bargain purchase option at the end of the term
The lease does contain a purchase option at less then market value at the end of the lease term (Bargain Purchase Option Test)
The lease term is less than 75 percent of the estimated economic life of the asset
The lease term is equal or greater than 75 percent of the estimated useful life of the asset (“75% test”)
The lessee uses less than 90 percent of the useful life of the asset.
The lessee uses 90 percent or more of the useful life of the asset. (“90% test”)
Result: Rent Expense recorded on a straight-line basis
Result: Capital Asset and Liability recorded, expense recorded as interest and depreciation.
Ownership Transfer Test
This distinction ensures that leases resulting in the transfer of ownership are treated as capital leases, reflecting the asset and liability on the balance sheet.
Bargain Purchase Option Test
Capital leases offer significant ownership benefits through bargain purchase options, distinguishing them from operating leases.
75% Economic Life Test
This test identifies leases that cover most of the asset’s useful life and thus should be capitalized.
90% Useful Life Test
High-utilization leases are treated as capital leases because the lessee derives most of the asset’s value.
Expense Recognition
This distinction affects how companies report expenses and impacts financial ratios and compliance reporting.
The Impact of ASC 842 on Lease Management
Historically, the vast majority of leases have been operating – and remained buried in the footnotes rather than appearing on the company balance sheet. However, with the new lease accounting standards already effective for public companies and the deadline approaching for private company compliance, it is estimated trillions of dollars will be moved to the balance sheet because now almost every lease will need to have a corresponding Right of Use (ROU) Asset and Lease Liability, regardless of classification type. Choosing a comprehensive, proven lease accounting, lease management and lease administration software from CoStar allows you to manage leases in the manner that best suits company practices, process and adhere to new ASC 842 guidelines.
