Capital vs. Operating
A lease is a financing transaction called a capital lease if it meets any one of four specified criteria; if not, it is an operating lease. Capital Leases are treated as the acquisition of assets and incurrence of obligations by the lessee. Operating leases are treated as current operating expenses.
The greatest difference between capital leases and operating leases is the impact each has on the balance sheet. A capital lease adds to both the asset and liability side of the balance sheet; operating leases do not affect the balance sheet at all.
If at least one of the following criteria is met, the lease should be accounted for as a capital lease.
- The lease transfers ownership of the property to the lessee by the end of the lease term.
- The lease contains a bargain purchase option.
- The lease term is equal to 75% or more of the estimated economic life of the leased property.
- The present value of the minimum lease payments equals or exceeds 90% of the excess of the fair value of the leased property to the lessor.
If the lease does not meet the criteria for a capital lease, then it shall be classified as an operating lease.