In lease accounting, you’ll come across three different terms for kinds of leases: operating lease, finance lease, and capital lease. In order to ensure that your accounting is accurate and in compliance with current standards, such as ASC 842, it’s important to understand the differences between them, as well as which one applies to any of your organization’s leases.
In this article, we’ll walk you through how to distinguish an operating lease from a finance lease or a capital lease, and we’ll explain how that difference will affect your accounting.
- At-a-glance overview of the differences
- Five criteria to identify lease types
- How to account for each type
Different lease classifications at a glance
The US Generally Accepted Accounting Principles (GAAP) recognize two classifications of leases: an operating lease and a finance lease.
An operating lease is a lease arrangement in which the lessor grants the lessee access to the asset on a limited-term lease, and the lessee returns the asset to the lessor at the end of the lease term if it isn’t renewed.
A finance lease is a lease arrangement that more closely resembles a purchase of the asset. A lease is considered a finance lease if one or more of five criteria are met, as outlined in ASC 842, which we’ll explain below.
“Capital lease” is merely the older term for what is now called a “finance lease” under ASC 842. But since it’s had years of widespread usage, you’ll still encounter plenty of people using the term “capital lease” interchangeably with “finance lease.” For our purposes, we’ll stick with the updated “finance lease” terminology for the rest of the article.
It’s also worth noting that under certain other accounting standards, such as IFRS 16 and GASB 87, you don’t need to make this distinction at all. So we’ll be focused on ASC 842 compliance for this article.
How to distinguish an operating lease from a finance lease
ASC 842 lists five criteria for identifying a finance lease. When a lease meets at least one of these five criteria, it is considered a finance lease, and thus not an operating lease:
- The lessee plans to exercise a purchase option at the end of the lease term.
- Ownership of the asset is transferred to the lessee at the end of the initial lease term.
- The asset has no other use to the lessor at the end of the lease term.
- The lease term is a major component of the asset’s economic life.
- The present value of lease payments is substantially all of the asset’s fair value.
These criteria identify which party bears the most liability for the asset according to the terms, duration, and costs of the lease and remaining value of the asset. Let’s take a look at each one in greater detail.
1. Purchase option
A lease is considered a finance lease if it includes an option to purchase the asset at the end of the term and the lessee intends to exercise that option. The leased asset isn’t an inherently greater liability for the lessee simply because the lessor includes a purchase option.
Lessees are expected to be “reasonably certain” that they will exercise the purchase option, meaning that they have performed due diligence to weigh all the relevant factors—taking into consideration the value of the asset, the terms of the contract, market conditions, etc.—and have confidence in their desire and ability to purchase the asset at the end of the term.
Purchase options are common for vehicle and equipment leases.
2. Ownership transfer
A lease is considered a finance lease if it transfers ownership of the asset from the lessor to the lessee at the end of the initial lease term.
This is similar to the previous criterion, but instead of the lease including a purchase option, it specifies that ownership of the asset will be transferred automatically with no additional payment.
This is generally more common if the sum of the lease payments is about the same as the asset’s fair market value or remaining economic life. And as with a purchase option, it’s common with vehicle and equipment leases.
3. No other use
A lease is considered a finance lease if the lessor will have no alternative use for the asset at the end of the lease term.
This often occurs because the leased asset is highly specialized. For example, a lessee might lease a custom-built piece of machinery that was designed specifically for their needs, but which would have no application outside of their own use case. When the lease term expires, the lessor will neither have reason to use the piece of machinery themself, nor can they be reasonably expected to find another lessee who could use it. It can also occur when a leased asset is installed in place, such that it cannot be easily uninstalled and put into use elsewhere.
In many cases, a lease that meets this criterion will also meet one or more of the other criteria. For example, the lessor, knowing they will have no use for the asset, may have the ownership transfer to the lessee at the end of the lease term so that they are not responsible for disposing of it. However, the “no other use” criterion is enough on its own for a lease to be considered a finance lease, even if no other criteria are met.
4. Asset’s economic life
A lease is considered a finance lease if the lease term makes up the major part of the asset’s economic life.
Economic life refers to the period of time during which an asset is expected to be useful. Eventually, a leased asset will cease to function as intended, or the costs of maintenance and operation will begin to outweigh any income the asset generates. An asset’s economic life is calculated by estimating that period of time based on normal usage. It can also take into consideration factors such as depreciation and new regulations that may render the asset unusable after a fixed period of time or hours of operation.
As for whether the lease term is the “major part” of the economic life, the previous lease standard of ASC 840 defined a specific threshold, saying that a lease is a finance lease if the term makes up 75% or more of the remaining economic life. Under ASC 842, that specific threshold has been removed as a requirement, providing some additional flexibility, though it suggests that organizations may continue to use 75%. And for the most part, 75% is still the generally accepted standard for making such a determination.
So if, for example, a new two-ton truck has an estimated economic life of six years, and an organization leases it for five years, then it would most likely be considered a finance lease.
However, ASC 842 includes an additional clarification that if a lease commences “at or near the end” of the economic life, then this criterion does not apply. The lessee isn’t receiving the majority of the asset’s lifetime benefit. Although it doesn’t mandate a specific threshold, ASC 842 suggests that 25% of an asset’s life may be a reasonable approach. At that point, the determination of whether the lease is a finance lease or not must rely on the other four criteria.
So if that two-ton truck with an economic life of six years was leased in a new lease term after it had already been in operation for five years, then this criterion would not apply to qualify the lease as a finance lease.
5. Present value
A lease is considered a finance lease if the present value of lease payments, as calculated at the commencement of the lease, is substantially all of the asset’s fair value.
Present value refers to the total value of unpaid lease payments over the course of the lease term. For the purposes of determining whether a lease is a finance lease, it refers to the value of all upcoming lease payments at the commencement of the lease term.
Fair value refers to the price at which an asset would be sold according to the market rates at the date of lease commencement. To determine the fair value of an asset, ASC 820 offers a hierarchy of inputs, with each subsequent level to be used only if inputs from the previous levels are unavailable.
- Level 1 includes quoted prices for identical assets in active markets.
- Level 2 includes quoted prices for similar assets in active markets, quoted prices for identical assets in non-active markets, and other observable inputs like interest rates and yield curves.
- Level 3 includes unobservable inputs based on the asset’s own data, including information like projected cash flows, discount rates, and growth rates.
For determining whether the present value is “substantially all” of the asset’s fair value, ASC 842 again removed the precise threshold that was previously specified under ASC 840. But the threshold from ASC 840, which in this case is 90%, continues to be the generally accepted standard. So for the most part, if the present value of lease payments at lease commencement is at least 90% of the fair value, then it is a finance lease.
Let’s say that, when reasonably accounting for discount rates and inflation, a lease for a used piece of machinery is valued at $24,000. If the same piece of machinery at a comparable age and in comparable condition can be consistently found in active markets for the price of $25,000, then that could be considered its fair value. In this case the present value of $24,000 for the lease payments is 96% of the fair value for the asset of $25,000, which would likely qualify the lease as a finance lease.
Accounting for an operating lease vs. a finance lease
The key accounting difference between the two is that you record an operating lease as an expense, whereas with a finance lease, you record the object of the lease as an asset, which is subject to depreciation.
At the commencement of either kind of lease, you must establish a right-of-use (ROU) asset and a lease liability, which you’ll reduce over the remaining lease term.
For an operating lease, you record the amortization of the ROU asset, but you don’t need to record the interest expense. You also classify payments as operating activities in the cash flows statement.
For a finance lease, you separately record both the amortization of the ROU asset and the interest expense on the lease liability. You also classify variable payments and interest as operating activities in the cash flows statement, and you classify principal repayments as financing activities.
The following table summarizes these accounting differences:
| Record type | Operating lease | Finance lease |
| Lease | Record the lease as an expense. | Record the object of the lease as an asset. |
| Amortization | Record the amortization of the ROU asset, but not the interest expense. | Separately record both the amortization of the ROU asset and the interest expense. |
| Payments | Classify payments as operating activities. | Classify variable payments and interest as operating activities. Classify principal repayments as financing activities. |
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