Operating Lease vs. Capital Lease: What’s the Difference?
Last updated on October 27, 2022 by
Equipment leasing involves multiple types of leases, but the two primary classifications include operating leases and capital leases.
As you learn more about your equipment leasing and financing options, you’ll want to understand some key structural differences between an operating lease and a capital lease.
Under the previous lease accounting standard, ASC 840, there were more differences between these two lease classifications than there are now. That’s because an accounting standard update, ASC 842, Leasing, created and issued by the Financial Accounting Standards Board (FASB), amended how operating leases are accounted for, making the differences in accounting treatment for each lease type more similar.
While the differences between operating leases vs. capital leases aren’t as significant under ASC 842, understanding each is still important to your decision-making process.
In this article, we will review:
- What are operating and capital leases?
- Operating and capital lease criteria
- The differences in accounting of each type
- The accounting and tax advantages of each type
Knowing the differences and uses of each lease classification will give you a better understanding of why your lease agreement is accounted for the way it is and how that accounting treatment can potentially benefit your business.
Excedr’s leasing program helps laboratories procure the lab equipment needed to perform R&D, scale operations, and commercialize. Interested in equipment leasing? Let us know.
Operating leases are contracts between the owner of an asset, known as the lessor, and the holder of the lease, known as the lessee, that grant the lessee the rights to use that asset for a specific period of time, without transferring the ownership rights of the asset to the lessee.
Historically, the payments you make towards the lease are accounted for as operating expenses and recorded on the income statement rather than the balance sheet, making operating leases a type of off-balance-sheet financing.
However, because of the recently enacted accounting standard, ASC 842, created by the Federal Accounting and Standards Board (FASB), a leased asset and the payments that go towards it must also be recorded on the balance sheet, including operating leases. Additionally, all operating leases that began before the new standard took effect need to be transitioned from the old standard, ASC 840, to the new standard.
Despite these changes, operating leases are still considered a type of rental agreement, due to the lack of transfer of ownership, the expensed lease payments, and, in some situations, the short-term length of the lease.
You’ll record the payments as rental expenses on your income statement and benefit from any corresponding tax deductions related to renting an instrument (similarly to renting office space). Operating leases are also not recorded as debt, which means they can be significantly less cumbersome when it comes to contract terms.
Capital leases, now referred to as finance leases under ASC 842, are defined as contracts between a lessor and lessee that, like an operating lease, grant the lessee the rights to use an asset. However, unlike an operating lease, a capital lease also involves:
- Treating the leased asset as if it were purchased for accounting purposes.
- The transfer of ownership of the asset from the lessor to the lessee at the end of the lease term.
Because of this, capital leases, or finance leases, are considered a purchase of an asset, and are accounted for on the balance sheet.
Furthermore, because it is considered a purchase, a capital lease is seen as more of a loan than a rental, and has a slightly different impact on a company’s financial statements, influencing its assets, liabilities, depreciation expense, and interest expense.
For example, with a capital lease, in the eyes of the IRS, you’re taking out a loan for your lab equipment. So instead of recording rental expenses on your income statement, you will record a debt on your balance sheet along with the corresponding principal payments. Capital leases also come with the burdensome terms of a bank loan, since they are identical debt instruments.
Capital leases, like debt, accrue interest. When tax season comes around, under current IRS rules, you can deduct the interest expense, but these deductions are typically lower than the rental expenses of an operating lease.
How Does the Equipment Leasing Process Work?
With equipment leasing, the process is generally the same regardless of whether you’re looking for an operating or capital lease.
To begin the approval process with a leasing company, you generally provide an instrument quote to the lessor showing how much the new, refurbished, or used instrument will cost, or even documentation of comparable instruments that illustrates a similar price and use.
For example, when you work with Excedr, you obtain the equipment quote from the manufacturer of your choice and send it to us in order to begin the approval process and initial discussions.
In general, the company you lease from will ask you for an instrument quote from the manufacturer, along with specific financial documentation that helps them with underwriting.
As an illustration, after you speak with someone at Excedr, we generally ask that you provide us with: a lease application, recent years’ corporate tax returns and financial statements, and any supplementary fundraising documentation to support your cash position.
With the proper documentation collected, our specific underwriting process can begin in earnest, allowing us to verify your company’s financials and determine the perfect lease for you. If and when you receive approval, we will:
- Create initial lease estimates that we can discuss together
- Provide a finalized lease agreement
- Finalize documentation
- Issue a PO (purchase order) on your behalf for the equipment you need from the manufacturer of your choice
In general, it can take anywhere from a few days to a few months to receive your equipment, depending on the manufacturer’s lead times. However, with the current supply chain issues, delivery times may take longer. It’s important to check in with the manufacturer early in the process and plan accordingly.
Operating Lease Criteria
For a lease to be classified as an operating lease, it must not meet any of the specific conditions on a list of criteria laid out under ASC 842. These conditions include:
- The transfer of ownership of the underlying asset to the lessee by the end of the lease term.
- An included purchase option in the lease agreement that grants the lessee the ability to purchase the asset at the end of the lease term.
- The lease term lasts longer than the major part of the asset’s remaining economic life.
- The present value of the sum of the lease payments is greater than or equal to “substantially all” of the FMV of the asset.
- The asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease term.
If the lease does not meet any of these conditions then your lease will, by default, be qualified as an operating lease and accounted for as such.
To learn more about operating leases, read our article, What is an Operating Lease?
Capital Lease Criteria
For a lease to be classified as a capital lease, it only has to meet one of the conditions laid out by ASC 842:
- There is transfer of ownership to the lessee at the end of the lease.
- A bargain purchase option is included, allowing the lessee to purchase the asset at a specific time for a significantly lower price than the fair value of that asset.
- The lease term lasts longer than 75% of the asset’s economic life.
- The lease payments have a present value, or PV, exceeding 90% of the asset’s fair market value.
- The asset is so specialized the lessor cannot resell it after the lease term.
In other words, if there is transfer of ownership, then the lease will be qualified as a capital lease and treated as such for accounting purposes.
Accounting Differences: Operating Lease vs. Capital Lease
Under the previous standard, ASC 840, there used to be a substantial difference between operating leases and capital leases when it came to accounting for one or the other. The standard required that operating leases only needed to be accounted for on the income statement, and did not need to be recorded on the balance sheet.
This type of off-balance-sheet financing allowed companies to reduce a lot of the impact operating leases had on the balance sheet, and could make the company appear, in some cases, to be more financially healthy than they really were. Users and reviewers of financial statements weren’t able to glean the insights they needed from the statements to provide a full picture of the company’s risks and liabilities.
With the new ASC 842 standard, FASB requires that every lease—except for short-term leases less than 12 months in length—be included on the balance sheet by recognizing a lease liability and a right-of-use (ROU) asset.
The lease liability represents the lessee’s obligation to make lease payments and is calculated as the present value of all known future lease payments. The ROU asset represents the lessee’s authority to use an asset under the lease agreement, and is measured as the lease liability’s starting amount plus any lease payments made to the lessor before the lease commencement date, plus any initial direct costs incurred, minus any lease incentives received.
Now, do the changes made under ASC 842 make operating leases and capital leases the same from an accounting perspective? Not entirely. While there are similarities to how each classification is accounted for initially, there remain some notable differences.
For example, a capital lease does involve the transfer of ownership rights to the lessee, and the lease is considered more of a loan, or debt financing. Unlike an operating lease, only the interest payments are expensed on the income statement. Due to capital leases being counted as debt, they depreciate over time and incur interest expense.
Furthermore, the present market value of the asset is included in the balance sheet under the assets side, and depreciation is charged on the income statement. On the other side, the loan amount, which is the net present value of all future payments, is included under liabilities.
Simply put, what this means is that operating lease payments are eligible for a tax deduction (because they’re considered operating expenses), while capital lease payments are not (because they’re considered debt).
Advantages of Operating Leases
Operating leases offer a number of advantages to companies. These include:
- A simpler way to account for a leased asset
- No risk of obsolescence, since there’s no ownership rights transfer
- Greater flexibility to replace and update equipment
- Tax-deductible lease payments
Advantages of Capital Leases
There are some advantages capital leases provide, including:
- The ability to claim depreciation on the leased asset, reducing taxable income
- The accrual of interest expense, which can also reduce a company’s tax liabilities
Parting Thoughts: Which Lease Makes More Sense?
We may be a little biased, but operating leases are always a sound financial decision. Looking at the current state of affairs in biotechnology, healthcare, and the life sciences in general, it makes even more sense to go with an option that provides you with a manageable and consistent payment method, and does not require an extensive cash outlay upfront.
In other words, with operating leases, you can hold onto a much larger amount of working capital, spread your costs out over time, and access the equipment you need to keep R&D going. Furthermore, if you’re eligible, you can potentially write off 100% of the lease payments, reducing your income tax liabilities.
Excedr’s equipment leasing helps you access the scientific instruments you need and spend money more wisely. Learn more about our Leasing Program.