Operating vs Capital Lease

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What are the criteria for classifying a lease as operating or capital? Why is there a difference between the two? What are the implications of an operating lease versus a capital lease on an entity’s financial statements?

The criteria and characteristics of operating lease is that operating lease usually a shorter-term lease under which the lessor is responsible for insurance, taxes, and upkeep. May be cancelable by the lessee on short notice.

The criteria and characteristics of capital lease is that capital lease is typically a longer-term, fully amortized lease under which the lessee is responsible for maintenance, taxes, and insurance. Usually not cancelable by the lessee without penalty.

To distinguish between the financial lease and the operating lease on financial statement, I will provide this example to illustrate how each type of lease differs in regards to accounting. Here is the example:

Imagine a firm that has $100,000 in assets and no debt, which implies that the equity is also $100,000. The firm needs a truck costing $100,000 (it’s a big truck) that it can lease or buy.

Financial leases are often called capital leases by the accountants. If the lease is a capital lease, then the truck is shown as an asset and the present value of the lease payments is shown as a liability. Here is how the balance sheet looks like with capital lease or financial lease.

Assets under capital lease$100,000Obligations under capital lease$100,000 Other assets$100,000Equity$100,000
Total assets$200,000Total debt plus equity$200,000

If lease is an operating lease, then neither the asset (the truck) nor the liability (the present value of the lease payments) appears. Here is how the balance sheet looks like with operating lease.

Truck$0Debt$0
Other assets$100,000Equity$100,000
Total assets$100,000Total debt plus equity$100,000
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