What is the difference between an operating lease and a finance (capital) lease?

Operating Lease vs Finance Lease

Leases are classified as either operating or finance (capital) leases based on whether risks and rewards of ownership transfer to the lessee.

Old Standards (pre-2019):

• Operating Lease: Rental arrangement
• Finance Lease: Essentially a purchase
• Different accounting for each type

New Standards (IFRS 16/ASC 842):

• Most leases treated as finance leases for lessees
• Operating lease treatment eliminated for lessees
• Lessor accounting largely unchanged

Old Standards Comparison

Operating Lease (Old Rules):

Short-term rental, lessee doesn't assume ownership risks.

• Accounting: Lease payments as rent expense
• Balance Sheet: No asset or liability
• Example: Office space rental for 3 years
• Journal Entry: Dr Rent Expense, Cr Cash

Finance/Capital Lease (Old Rules):

Long-term lease, effectively a purchase.

• Accounting: Record asset and liability
• Balance Sheet: Asset and loan liability
• Example: Equipment lease for 80% of life
• Journal Entry at start: Dr Equipment, Cr Lease Liability
• Journal Entry each period: Dr Interest Expense, Dr Lease Liability, Cr Cash

Old Classification Criteria (IAS 17):

Finance lease if ANY of these apply:

1. Ownership transfers at end of lease
2. Bargain purchase option exists
3. Lease term ≥ 75% of asset's economic life
4. Present value of payments ≥ 90% of asset's fair value
5. Asset specialized for lessee

If none apply → Operating lease

New Standards (IFRS 16/ASC 842)

Key Changes:

• Effective dates: IFRS 16 (2019), ASC 842 (2022 for public companies)
• Lessee accounting: All leases (except short-term/low-value) are finance leases
• Lessor accounting: Similar to old standards
• Purpose: Bring leases onto balance sheet

New Lessee Accounting:

For all leases (except exemptions):

1. Record Right-of-Use (ROU) asset
2. Record lease liability at present value of payments
3. Depreciate ROU asset over lease term
4. Recognize interest expense on liability

Example - Office Lease under IFRS 16:

• 5-year office lease, annual payments $20,000
• Interest rate: 5%
• Present value of payments: $86,590
• At commencement:
  • Dr ROU Asset $86,590
  • Cr Lease Liability $86,590
• Year 1 payment:
  • Dr Interest Expense $4,330 (5% × $86,590)
  • Dr Lease Liability $15,670
  • Cr Cash $20,000
• Year 1 depreciation:
  • Dr Depreciation Expense $17,318 ($86,590 ÷ 5)
  • Cr Accumulated Depreciation - ROU $17,318

Exemptions (Still Operating Lease Treatment):

1. Short-term leases: ≤ 12 months
2. Low-value assets: Below company's materiality threshold (e.g., $5,000)

Financial Statement Impact - New vs Old:

Practical Implications:

For Lessees:

• Increased assets and liabilities on balance sheet
• Higher EBITDA (rent expense removed)
• Worse debt/equity ratios
• More complex accounting
• Need to track all leases systematically

For Lessors:

• Similar to old standards
• Still classify as operating or finance lease
• Finance lease: Recognize receivable, derecognize asset
• Operating lease: Keep asset, recognize rental income

Key Differences Summary:

Important Notes:

1. New standards apply prospectively (existing leases recognized)
2. Transition requires significant effort for companies with many leases
3. Software often needed to calculate present values and track leases
4. Disclosure requirements increased significantly
5. Companies may try to structure leases to qualify for exemptions
6. Auditors focus heavily on lease accounting under new standards

Key Points to Remember:

1. Old standards: Two different treatments based on classification
2. New standards: Most leases on balance sheet for lessees
3. ROU asset = right to use asset, not ownership
4. Lease liability = present value of future payments
5. Exemptions exist for short-term and low-value leases
6. Lessor accounting largely unchanged