7/29/2019 Lease Classifications - When to Use Operating vs Capital Leases

What are Lease Classi cations?

Lease classi cations include operating leases and capital leases. A lease is a type of
transaction undertaken by a company to have the right to use an asset. In a direct purchase,
a company will simply purchase the asset o of another party. In a lease, however, the
company will pay the other party an agreed upon sum of money, not unlike rent, in
exchange for the ability to use the asset.

The company purchasing the right to use the asset is known as the lessee. The party
o ering the asset for lease, and consequently receiving the lease payments, is known as the
lessor. Leases generate an interest expense in certain situations.

There are two types of lease classi cations: the operating lease and the capital or nance
lease.

What is an Operating Lease?

In an operating lease, the lessee receives the right to use the asset but does not record the
asset or the lease payment liability on its balance sheet. Thus, the operating lease is
considered to be “o -balance sheet nancing”. Instead, the lessee will record lease
payments as rental expense in its income statement, either under cost of goods sold or
under SG&A.

What is a Capital or Finance Lease?

In a capital lease, the lessee receives the right to use the asset and substantially receives all
the bene ts and risks of owning that asset. This transfer of risk and bene ts can occur when
certain criteria are met. A capital lease can be assumed if:


https://corporatefinanceinstitute.com/resources/knowledge/accounting/lease-classifications/ 1/3
7/29/2019 Lease Classifications - When to Use Operating vs Capital Leases

The lease duration is 75% or more of asset’s useful life;

The net present value (NPV) of lease payments is 90% or more of the asset’s fair value;
There is a direct term or clause in the lease stating transfer of title; or,
There is a term in the lease that allows the lessee, at the end of the lease, to purchase
the asset at a discounted price (also known as a bargain purchase option, or BPO).

As opposed to the operating lease, a lessee in a capital lease will record the asset and the
corresponding lease liability in its balance sheet. The asset will be classi ed as plant,
property and equipment while the lease liability is classi ed as a form of debt.

The lessee will also depreciate the asset over time, simply to the salvage value of the asset.
If the lessee and lessor have agreed on a guaranteed residual value, which is a contractual
agreement to return the asset at a certain market value, then the lessee will depreciate the
asset over time to this residual value.

Any non-cash nancing for this lease is disclosed in the footnotes of the containing nancial
statement.

Signi cance of the Lease Classi cations

Because of the nature of each lease classi cation, there can be an impact on pro t and debt
capacity. Since operating leases are o -balance sheet, the company’s capital structure does
not change due to the operating lease. In contrast, a capital lease may make a company
more debt-heavy, thereby impacting its debt capacity.

To learn more, launch our free accounting courses!

More Resources
Thank you for reading CFI’s guide to lease classi cations. To further advance your nancial
education, see the following resources:

Debt-to-Equity Ratio
Investment Methods
Three Statement Model
Return On Equity

https://corporatefinanceinstitute.com/resources/knowledge/accounting/lease-classifications/ 2/3
7/29/2019 Lease Classifications - When to Use Operating vs Capital Leases

Free Accounting Courses

Learn accounting fundamentals and how to read nancial statements with CFI’s free online
accounting classes.
These courses will give the con dence you need to perform world-class nancial analyst
work. Start now!

Building con dence in your accounting skills is easy with CFI courses! Enroll now for FREE to
start advancing your career!

https://corporatefinanceinstitute.com/resources/knowledge/accounting/lease-classifications/ 3/3