How an Operating Lease Differs From a Capital Lease and Accounting for Each

by Craig Anthony

1 min read

An operating lease is an agreement that allows you to use or occupy property without the benefits or risks of ownership. The property may be real or personal property, such as heavy equipment, machinery, or vehicles. A fundamental difference exists between an operating lease and a capital lease. Under a capital lease, you acquire an ownership interest in the property. You must show the property as a depreciable asset on your balance sheet. Because an operating lease gives you no ownership stake, you can omit the property as an asset on your balance sheet, but you may list the lease payments as operating expenses on your income statement and deduct them from revenues. Deducting the lease payments as expenses from income can have a dramatic effect on your tax liability. This accounting method tempts many companies to try to hide assets by structuring purchases and financing arrangements as operating leases, but generally accepted accounting principles attempt to correct this by limiting operating leases to four requirements:

  • The length of the lease cannot exceed 70% of the life span of the property.
  • The present-day value of lease payments cannot exceed 90% of the fair market value of the property.
  • There may be no bargain purchase price option involved.
  • Ownership cannot transfer to the lessee at the end of the lease.

If any of these conditions applies, you must capitalize the lease and include the property as an asset on your balance sheet. An operating lease is a rental agreement that transfers possession and use, but not ownership, of property. A capital lease differs from an operating lease by transferring ownership, and it requires that you record the property as an asset on your balance sheet. An operating lease does not transfer ownership, so you do not have to report the property as an asset; however, you may report lease payments as expenses on your income statement and deduct them from revenue. Because of the tax implications, generally accepted accounting principles require several conditions to exist to consider a lease an operating lease.

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