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Home > Balance Sheets Calculations > Distinguishing between a Capital and an Operating Lease

Balance Sheets Calculations

Distinguishing between a Capital and an Operating Lease

Getting Started

Determining whether a lease obligation is an operating or capital lease, for financial reporting purposes, requires that it be evaluated on the basis of four criteria established by the FASB (Financial Accounting Standards Board). The criteria are objective rules for making a judgment about who, the lessor or the lessee, bears the risks and benefits of ownership of the leased property.

If a lease is determined to be a capital lease, an asset and corresponding liability are recorded at the present value of the minimum lease payments. The capital asset is depreciated over time, while the liability is amortized as lease payments are made. Rental payments under operating leases are simply expensed as incurred. Due to the complexity of lease agreements, management judgment still plays a large role in distinguishing between operating and capital leases.

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What are minimum lease payments?

The minimum lease payments are the rental payments to be made during the lease term, plus the amount of the bargain price, guaranteed residual value, or penalty for failure to renew the lease at the end of its original term.

In determining whether a lease should be classified as an operating or capital lease, what interest rate should be used?

The interest rate used to discount the minimum lease payments to their present value is the incremental borrowing rate of the lessee, this being the interest rate that the lessee would have been charged if the assets had been acquired by borrowing the purchase price. If the lessor’s implied interest rate for the lease is known and is lower than the lessee’s estimated incremental borrowing rate, then the lessee uses the implied rate to discount.

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Making It Happen

The Four FASB Criteria

Until the 1970s, many companies used leasing as a means to purchase tangible assets without recognizing their ownership or the lease obligation on the balance sheet. In substance, leases were off-balance-sheet financing. Although all leases were required to be disclosed in the footnotes to the financial statements, even long-term finance leases did not appear as a liability. Because the basic measures of leverage do not consider off-balance-sheet obligations, the accounting profession and the investment community believed that there needed to be more stringent guidelines for classifying leases as operating or financing, and in 1976 the FASB issued Statement no. 13, “Accounting for leases.” The statement sets out four criteria to distinguish between an operating and a capital (finance) lease:

  • The lease agreement transfers ownership of the assets to the lessee during the term of lease.

  • The lessee can purchase the assets leased at a bargain price, such as $1, at the end of the lease term.

  • The lease term is at least 75% of the economic life of the leased asset.

  • The present value of the minimum lease payments is 90% or greater of the asset’s value.

If a lease agreement does not meet any of these criteria, the lessee treats it as an operating lease for accounting purposes. If, however, the agreement meets one of the above criteria, it is treated as a capital lease.

Accounting for a Capital Lease

Capital leases are reported by the lessee as if the assets being leased were acquired and the monthly rental payments as if they were payments of principal and interest on a debt obligation. Specifically, the lessee capitalizes the lease by recognizing an asset and a liability at the lower of the present value of the minimum lease payments or the value of the assets under lease. As the monthly rental payments are made, the corresponding liability decreases. At the same time, the leased asset is depreciated in a manner that is consistent with other owned assets having the same use and economic life.

Accounting for an Operating Lease

If the lease is classified as an operating lease, the monthly lease payments are simply treated as rental expenses and recognized on the income tax return as they are incurred. There is no recognition of a leased asset or liability.

Clearing Up Remaining Confusion

The FASB’s attempt to establish objective criteria for distinguishing between operating and capital leases was a good first step. This has enabled companies to make prudent financial decisions in lease versus buy situations, based on the accounting treatment afforded a specific lease structure. Furthermore, financial professionals now have a framework within which to determine what lease terms create a capital lease. However, the use of financial engineering still occurs. Consequently, many leases that are truly financing leases are recorded as operating leases, because their provisions have been altered to avoid qualification as capital leases.

When in doubt, a manager should always ask whether the risks and benefits of ownership have truly been passed from the lessor to the lessee. Facts indicating that the transfer has occurred are when maintenance, insurance, and property tax expenses are borne by the lessee, or when the lessee guarantees a specific residual value on the leased property.

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Further reading on Distinguishing between a Capital and an Operating Lease


  • Institute of Chartered Accountants in England and Wales (ICAEW):
  • Securities and Exchange Commission (SEC; US):

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