A lease is a financial agreements where lessor i.e. the owner of assets, buys the asset and allow the lessee i.e. user of assets, to utilize the asset for a restricted timeframe against intermittent installments. The document where terms and conditions in regards to the lease are given is called as Lease Deed.

There are two sorts of leases,

  1. Capital Lease and
  2. Operating Lease.

Capital lease is form of lease where rewards and risks are conveyed to lessee with the exchange of advantage. Whereas operating Lease only grants temporary usage rights without transferring the rewards and risks to the lessee.

In this article we are going to explain the differences between these two forms of lease i.e. capital lease and operating lease.

Capital Lease

Capital lease is an agreement where lessor permits the lessee to utilize a specific asset, for an altered term which covers the significant part of economic life of asset, While the title is not immediately transferred, the risks and rewards of ownership are passed on to the lessee.. It is otherwise called finance lease.

At the end of the lease term, the lessee typically has the option to buy the asset at a nominal price. This structure resembles a loan agreement, and cancellation usually results in losses borne by the lessee. In accounting, depreciation and finance charges are deductible for the lessee.

For a better understanding of how capital allocation works, explore the difference between fixed capital and working capital.

Operating Lease

Operating lease is an agreement where the lessee is permitted to utilize a asset with the consent of the lessor, for a restricted term which is by and large littler than the economic life of asset, without the purchasing option of title, rewards and risks.

This lease functions like a rental agreement. The lessee records rental expenses, but not the asset or depreciation. The lease can usually be canceled by either party. All costs for maintenance and repairs are borne by the lessor, not the lessee.

This arrangement is commonly used for short-term needs, such as office equipment or vehicles. To see how operating strategies differ in business, check the difference between mission statement and vision statement.

Capital Lease VS Operating Lease

Aspect Capital Lease Operating Lease
Definition A financial agreement where lessor permits the tenant to utilize the asset for the most extreme part of asset’s economic life against installment of rentals is called as capital lease. A financial agreement where lessor permits the tenant to utilize the assets for a smaller time period as compare to economic life of assets against the installment of rentals is called as operating lease.
Nature Capital lease is a loan agreement. Operating lease is a rental agreement.
Time Period The time period of capital lease is more and longer when compare with operating lease. The time period of operating lease is less and short.
Ownership In capital lease, the ownership of asset may be given to lessee, when the time period of lease term comes to an end. In operating lease, the ownership of assets always retained by lessor, in lease term and after that lessor is the owner of asset.
Rewards and Risks In capital lease, rewards and risks are transferred to lessee from the lessor, in addition to transfer of asset. In operating lease, rewards and risks are not transferred to lessee from lessor, in addition to transfer of asset.
Repairs and Maintenance In capital lease, all costs, repairs and maintenance are born by lessee. In operating lease, all costs, repairs and maintenance are born by lessor.
Tax In capital lease, finance charges and depreciation are allowed as deduction to lessee. In operating lease, lease rent is allowed as deduction to lessee.

 

Lease Smart, Not Hard: Which One Fits Your Business?

Deciding between an operating lease and a capital lease isn’t an accounting decision. It’s your long-term strategy. It is just like deciding whether or not to rent an apartment or purchase a home. Both are used for a different purpose.

A capital lease is best if you need to own an asset outright and require it in the long term. It is a good option for companies wanting to accumulate equity or stretch out costs over the long term. Because the asset is yours at the end of the lease, it is more like purchasing—with advantages such as depreciation and asset recognition.

At the same time, an operating lease is ideally adaptable to flexibility. If you’re constantly changing technology or have equipment needs on a temporary basis, this arrangement makes life easy. You don’t end up owning the property, but you don’t take on maintenance, resale value, and depreciation risks either. It’s inexpensive over the short term and keeps liabilities off your balance sheet.

Above all, align your lease agreement with your business strategy to begin with. Small companies and startups may find the freedom of operating leases helpful, while expanding businesses placing long-term infrastructure investments may prefer capital leases.

Whatever the case, making an educated decision provides your business with financial control and operational stability. Leasing is not merely employing an asset—it’s making a savvy decision about your assets.