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Capital Lease Vs. Operating Lease

Scholasticus K Jan 9, 2019
One of the best alternatives to avoid extremely expensive purchase is to take up assets on a lease. Capital lease and operating lease are two types of contracts available.
You will often find employees in the accounts and finance department having a debate regarding operating versus capital leases. These 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 contract. The fact is that, both are equally advantageous, and each type proves to be more suitable than the other according to a given situation.

What is a Lease?

A lease is basically a contract between a lessor and a lessee. A lessor is a person who gives out the said property or asset for rent, and a lessee takes the asset on 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 behalf of the parties involved. The contract contains details of the lease, such as the time period for which the asset is to be rented out, the mode and value of payment of the rent, etc.

Capital Lease

The concept of 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 contract has a long-term duration, high rate of rent, and the principal cost of the asset that is being leased out is also quite high.
✦ 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 contract is usually high.
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 a capital lease contract. The operating lease is also for smaller assets and for a shorter time duration.
✦ 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', and is taken to ensure that the assets are not damaged beyond repair. In case the assets get damaged, the amount of repair or replacement is deducted from the deposit.
For small business, an operating lease is favorable. An excellent example of an operating lease is the computers that are rented out to companies for a year or so.