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What Is A Capital Lease Versus An Operating Lease?

What is a capital lease versus an operating lease?

Under prior lease accounting guidance (ASC 840 and IAS 17), an operating lease was not reflected on the balance sheet and payments were expensed on a straight-line basis.  On the other hand, a capital lease was treated more as a loan, and the asset was reflected on the balance sheet.

For comparison purposes, here are five distinctions between capital leases and operating leases, based on FASB’s “bright-line” tests (only one had 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.

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.

Matt Waters, CPA

Lease Accounting Subject Matter Expert with over 15 years of Management Experience in Accounting and Finance