Capital Lease Vs. Operating Lease

You will often find that the accounts and finance department employees having a debate, operating versus capital leases. The capital lease and operating lease are two different classifications of lease contracts. The basic lease and the contract of these types of leases, remain the same. However, there is a considerable difference in some aspects, such as the time duration as well the total cost of the lease contract. The fact is that common lease as well as operating lease are equally advantageous and, irrespective of the outcome of the debate, each type of lease proves to be more suitable than the other lease, according to the situation. Let us have a look at the features of the operating lease and capital lease.

What is a Lease?

A lease, is basically a contract, between the lessor and the lessee. The lessor is the person, who gives out the said property or asset for rent, and lessee who takes the asset for rent. Sometimes, the lessee is also termed to be the 'tenant' of the asset. The contract of the lease is a very important document that is put down on paper by an attorney or lawyer, on the behalf of the lessor and lessee. The contract is a document that contains details of the lease, such as the time period for which the asset is to be rented out or the mode and value of payment of the rent, etc.

Capital Lease Vs. Operating Lease

Capital Lease
The concept of the capital lease as the name suggests, is a capital investment that is used to lease out equipment, property or any other asset. As the name suggests, the lease contract has long term duration (i.e. a long time period of lease), high rate of rent and the principal cost of the asset that is being leased out is also quite high. The following are some important characteristics of capital lease.

• The title of ownership is transferred from the lessor to lessee, when the time period of the lease commences.
• The lessee, has to show the depreciation of these assets in the annual profit and loss, statement.
• In some case, where the title of ownership is not passed on to the lessee, these assets are shown on the liability side of the balance sheet.
• Usually the term of the lease exceeds 75% of the useful estimated lifetime of the asset.
• In some cases, the lease also contains a clause which enables the lessee to purchase the asset.
• The monetary value or consideration for the lease contract is usually high and often expensive.

Heavy machinery, real estate and large-sized automobiles such as buses and trucks are some prominent examples of assets that come under the heading of capital lease. Tax advantages that are received by the lessee are greater for capital leases.

Operating Lease
An operating lease as the name suggests is a contract that rents out assets for operation. The cost of getting an operating lease is smaller and affordable, if compared to the capital lease contract. The operating lease is also for smaller assets and for a shorter time duration. The following are some important characteristics of operating leases.

• An operating lease, has a shorter time duration, that may stretch only for a few months.
• The cost of obtaining such leases, is often low and the total sum can be easily repaid in a few months time. Some companies tend to offer a lump sum payment to avoid repetitive transactional costs.
• The total cost of the lease is shown only in the profit and loss statement as the title of ownership does not pass on to the lessee.
• Usually the contract agreement of such a lease does not mention a purchase clause at the end of the term of the lease.
• In some cases, the lessee has to pay the lessor, a monetary sum that is equal to the value of the assets, before taking over the assets. This sum is repaid to the lessee after the term of the lease gets over. This transaction is referred to as the 'deposit' of the lease, and is taken to ensure that the assets are not damaged beyond repair. In case if the assets get damaged, the amount of repair or replacement, is deducted from the deposit.

For small business, the operating lease receives the favorable end. An excellent example of an operating lease is the computers that are rented out to companies for a year or so.

While comparing capital lease and operating lease the important thing is to use the appropriate lease in appropriate situations.