Operating Leases vs. Capital Leases
“Opex or Capex — Pick Your Power Play”
Operating Leases vs. Capital Leases:
Choosing the Right Equipment Financing Structure
When leasing equipment, business owners typically choose between two main types of leases: Operating Leases and Capital Leases (also referred to as Finance Leases). Understanding the differences between these two can help you make the most cost-effective and strategic financing decision.
Note: updated accounting standards issued by the Financial Accounting Standards Board (FASB),
which became effective for most private companies in 2022 changed operating lease accounting. (more below)
What Is an Operating Lease?
An Operating Lease is essentially a rental agreement. It allows your business to use the equipment for a specific period without the intention of ownership. At the end of the lease term, you can return the equipment, renew the lease, or sometimes upgrade to newer equipment.
Key Features:
No ownership: The lessor retains ownership; you’re only paying for the right to use the asset.
Shorter terms: Typically shorter than the useful life of the equipment.
Flexible end-of-term options: Return, renew, or upgrade.
Balance sheet impact: Recent accounting changes typically require them to be reported similarly to finance leases.
Ideal For:
Technology or medical firms where equipment becomes obsolete quickly.
Businesses wanting to avoid ownership and maintenance responsibilities.
Those seeking maximum flexibility or needing to keep debt off their balance sheet.
Benefits:
Lower monthly payments.
Potential tax deductions as a rental expense.
Easier to upgrade to newer models.
What Is a Capital Lease (Finance Lease)?
A Capital Lease, now often called a Finance Lease, is structured more like a loan. You lease the equipment for most of its useful life, and either automatically or optionally gain ownership at the end of the term—usually for a nominal buyout price (e.g., $1).
Key Features:
Ownership benefits: Treated as if you own the equipment for accounting and tax purposes.
Longer terms: Covers most or all of the asset’s useful life.
Buyout option: Often includes a fixed purchase price or nominal buyout at the end.
Balance sheet impact: Equipment and lease liability are recorded on your books.
Ideal For:
Businesses that plan to own and use equipment long-term.
Companies acquiring high-value assets like industrial machinery or fleet vehicles.
Situations where depreciation and asset ownership are tax-advantageous.
Benefits:
Depreciation and interest expense may be tax-deductible.
Typically leads to ownership.
Good for building equity in long-life assets.
Comparison Summary
| Feature | Operating Lease | Capital (Finance) Lease |
|---|---|---|
| Ownership | Remains with lessor | Typically transfers to lessee |
| Balance Sheet Impact | Now recorded as a liability (ASC 842) | Recorded as an asset and liability |
| Term Length | Shorter than asset’s useful life | Spans most or all of the asset’s life |
| Monthly Payments | Typically lower | Typically higher |
| End-of-Term Options | Return, renew, or upgrade | Buyout (often $1 or fair market value) |
| Maintenance Responsibility | Often handled by lessor | Usually handled by lessee |
| Tax Treatment | Payments often deductible as rent | May deduct depreciation & interest |
Operating Lease Examples
Technology Company – Computer Equipment
- Scenario: A software startup leases high-end servers for 24 months.
- Terms: The lease is short-term, the company doesn’t plan to own the servers, and they upgrade every two years.
- Treatment: It’s classified as an Operating Lease—the servers are used temporarily, returned at the end, and payments are expensed.
Medical Practice – MRI Machine
- Scenario: A clinic leases a $500,000 MRI machine for 3 years from a manufacturer.
- Terms: Maintenance is included, and there’s no intention to buy the machine.
- Treatment: Operating Lease—no ownership, lower monthly payments, offloads maintenance risk.
Retail Chain – POS System
- Scenario: A retailer leases point-of-sale systems for 18 months.
- Terms: The equipment will be swapped for newer models at lease end.
- Treatment: Operating Lease—short-term use, frequent upgrades, no ownership.
Capital Lease (Finance Lease) Examples
Construction Company – Excavator Purchase
- Scenario: A contractor leases an excavator for 6 years with a $1 buyout at the end.
- Terms: The lease spans most of the asset’s useful life, and the contractor plans to own it.
- Treatment: Capital Lease—meets criteria for ownership transfer, shows up as an asset and liability on the balance sheet.
Logistics Firm – Delivery Trucks
- Scenario: A shipping company enters a 5-year lease for 10 trucks.
- Terms: The trucks are essential for operations, and the company will purchase them at the end for a set price.
- Treatment: Capital Lease—long-term control and purchase intent.
Manufacturer – Industrial Robot Arm
- Scenario: A factory leases a robotic arm with a 10-year term and the option to buy at fair market value.
- Terms: The lease term covers most of the asset’s useful life.
- Treatment: Capital Lease—the business essentially owns and depreciates the equipment.
Which Lease Is Right for You?
Choose an Operating Lease if you prioritize flexibility, plan to upgrade regularly, or want lower payments and minimal maintenance responsibilities.
Choose a Capital Lease if long-term use and ownership make sense for your operations, especially if the equipment retains value over time.
Understanding How Lease Accounting Has Changed
“Getting into the weeds of ASC 842″
Historically, Operating Leases were considered “off-balance-sheet” arrangements. This meant businesses could use equipment without recording the lease obligation as a liability or the asset on their financial statements — a strategy many companies used to improve financial ratios and appear less leveraged.
However, that changed with the introduction of ASC 842, a lease accounting standard issued by the Financial Accounting Standards Board (FASB), which became effective for most private companies starting in 2022.
What Is ASC 842?
ASC 842 is the updated lease accounting standard that aims to improve transparency and comparability by requiring companies to record most leases on their balance sheets — even Operating Leases.
Under ASC 842:
- Both Operating and Finance Leases must now be reported on the balance sheet.
- Companies must recognize a:
- Right-of-Use (ROU) Asset – representing the right to use the leased equipment.
- Lease Liability – representing the present value of future lease payments.
Key Implications for Operating Leases
Before ASC 842 | After ASC 842 |
Operating leases were off the balance sheet | Operating leases are now on the balance sheet |
Only disclosed in footnotes | Must be formally recorded as liabilities and assets |
No impact on debt ratios | May affect debt-to-equity, working capital, and credit metrics |
Why This Matters to a Business Owner
- Financial Reporting Impact: Your balance sheet will now reflect more liabilities, which can affect loan covenants, borrowing capacity, or investor perception.
- Compliance: Failing to comply with ASC 842 can lead to audit issues or delays in financial reporting.
- Technology & Process Changes: Businesses often need updated accounting systems or software to manage and calculate lease data properly under the new standard.
- Decision-Making: When evaluating whether to lease or buy, you must now factor in the balance sheet impact of leases — not just cash flow or tax benefits.
Exception: Short-Term Leases
ASC 842 provides an exemption for short-term leases (12 months or less, with no purchase option). These can still be excluded from the balance sheet if the business elects to treat them that way consistently.
Final Thought
While ASC 842 adds complexity, it also creates a more accurate financial picture of your business’s obligations. When considering an operating lease, consult with your accountant or CFO to fully understand how the lease will be treated — and how it may affect your financial reporting and performance metrics.