Capital Lease vs Operating Lease

Lease is agreement between owner of property and the person who wants to use of same property. It is contract of rent of any fixed asset.

1. Definition

Capital lease is the lease on the basis of rules

1) Ownership of asset will transfer at the end of lease

or
2) It allows lessee to buy same leashold asset the price less than fair market value at the end of lease.

In operating lease, there is not such rule. Both reward and risks will be of owner instead lessee.



2. Plan


Capital lease is the plan to buy asset in the installment

So, lease property will be an asset and  if there will be any default, it will be liability of lessee.

Operating lease is just agreement of rent property. Ownership will not transfer. All default in property will be of owner. He is responsible and it is his liability.

3. Lease Term

In Capital Lease

75% of total active life of asset must be under lease term. Means capital lease contract should not short term. It should be long term. It is condition.


In Operating Lease

In operating lease, lease contract may be short term.

4. In Financial Statement

In Capital lease 

We will show total value of asset in balance sheet as fixed asset

For example, asset value is Rs. 10,00,000

It will be shown in the asset side in the beginning of lease agreement and same amount will be as liability by showing lease payable account

In operating lease

We will not show it in balance sheet of lessee. We will show only in income statement. When we pay the lease amount, it will be expense like paying of other operating  expenses like rent, internet bill and electricity bill.


5. Installment Rule

In capital lease

When we pay the lease amount, it will apply installment rule

following entry will pass

In above example, we have taken capital lease of machine of Rs. 10,00,000. We have decided to pay Rs. 5000. Now, because at the end of lease, this will be the asset of lessee. So, lessee will show installment as ( principle + interest ) like payment of any other loan.

lease payable account debit

interest account Credit (interest on principle )

Bank account Credit ( Principle of installment )

In operating lease

This rule will not apply

Related : Journal Entries of Lease