Difference Between Operating Lease and Capital Lease

Key Difference – Operating Lease vs Capital Lease
 

Companies require a number of tangible assets that can be purchased or leased. Purchasing a tangible asset requires a lump of funds at once, thus it will not be viable for all companies. Alternatively, leasing is a convenient option since the payment can be made on installment basis. Operating lease and capital lease are the two options available if the decision to lease is being considered. In both cases, periodic lease payments are made to the party owning the asset by the party who obtains the lease. The key difference between operating lease and capital lease is that the asset has to be transferred back to the owner at the end of the lease period in operating lease, whereas the ownership of the asset is transferred to the party who leases the asset at the end of the lease agreement in the capital lease.

CONTENTS
1. Overview and Key Difference
2. What is Operating Lease
      – Accounting for Operating Leases
3. What is Capital Lease
      – Accounting for Capital Leases
4. Side by Side Comparison – Operating Lease vs Capital Lease
5. Summary

What is Operating Lease?

Under an operating lease agreement, the lessor (the party who grants the lease; in most cases, this is a leasing company) transfers the asset to the lessee (the party who acquires the lease) to be used in business operations. The ownership of the asset continues to remain with the lessor and lease payment is payable by the lessee for the use of the asset. Accounting guidelines for Operating Lease are provided under IAS 17– ‘Leases’.

Accounting for Operating Leases

The recording of an operating lease payment is much less complicated compared to a capital lease. Lease payments should be recorded as an expense in the income statement over the lease period on a straight-line basis (same installment for every year). Lease payments will be recorded as an expense and will reflect in the income statement under operating expenses.

E.g. ABC Ltd (lessee) leases a building of $200,000 for a period of 10 years from DEF leasing company (lessor) Lease payment per annum is $20,000.

Entries for ABC Ltd,

Rent A/C                                 DR$20,000

Cash A/C                                CR$20,000

What is Capital Lease

Ownership of the asset will be transferred to the lessee at the end of the lease agreement upon payment of the final lease installment. This type of lease is also commonly named as a ‘finance lease’. At the commencement of the lease term, finance leases should be recorded as an asset by the lessee. The finance charge for the lease as well as the reduction in the outstanding liability should be shown in the financial statements. The lessee should also charge depreciation on the asset based on the company policy. IAS 17 states that the depreciation policy should be the same for both owned and leased assets.

Accounting for Capital Leases

Accounting for a capital lease is complicated than an operating lease and following steps should be followed.

Step 1: Initial Recognition of the Asset

For this, the present value of all lease payments has to be calculated and this amount will be recorded as the cost of the asset.

E.g. PQR Ltd leases a vehicle which has a present value of lease payments of $150,000. The double entry will be,

Building A/C                                              DR$150,000

Capital lease liability account A/C               CR$150,000

Step 2: Lease Payments

Lease payments should be made periodically where the payment contains a portion of interest and capital payment. Gradually, as the lease payments progress, the balance in the capital lease liability account will be reduced to zero. (due to the capital payments) Considering the above example,

E.g. Lease payment is $1,500 which is apportioned as $250 for interest and $1,250 for capital payment.

Capital lease liability account A/C          DR$1,250

Interest expense A/C                            DR$250

Accounts payable A/C                          CR$1,500

Step 3: Depreciation

Depreciation should be charged for the asset based on company depreciation policy. Continuing from the same example,

E.g. the vehicle valued at $150,000 has an economic useful life of 5 years with no resale value. Thus the depreciation charge per annum is $30,000 ($150,000/5)

The double entry for this is,

Depreciation A/C                                       DR$30,000

Accumulated depreciation A/C                   CR$30,000

What is the difference between Operating Lease and Capital Lease?

Summary – Operating Lease vs Capital Lease

The main difference between operating lease and capital lease is dependent on the party that bears the ownership of the asset. Operating lease is convenient to account for and is a simple arrangement where rent payments are made. The capital lease, on the other hand, requires the lessee to bear all the costs during the lease period,; however, the most significant advantage in this is that  once the lease payments are completed, the asset belongs to the lessee, thus capital lease is a popular asset financing method among many businesses.

Reference:
1. “IAS Plus.” IAS 17 – Leases. N.p., n.d. Web. 22 Feb. 2017.
2. “What is the accounting for a capital lease? – Questions & Answers – AccountingTools.” Accounting CPE & Books – AccountingTools. N.p., n.d. Web. 22 Feb. 2017.
3. “ACCA – Think Ahead.”  ACCA Global. N.p., n.d. Web. 22 Feb. 2017.
4. “Effects Of Capital Vs. Operating Leases – CFA Level 1.” Investopedia. N.p., 18 Apr. 2008. Web. 22 Feb. 2017.

Image Courtesy:
1. “Illustration-of-New-Lease-Accounting-TRIRIGA” By Johnclark1968 – The New Lease Accounting Standard and You, TRIRIGA Inc., July, 2010 (Public Domain) via Commons Wikimedia