Lesson 50 - Intermediate Accounting Course 

50. Accounting for Operating vs. Capital Leases in Detail

Leasing is a common way for businesses to acquire assets without purchasing them outright. There are two primary types of leases: operating leases and capital leases (finance leases). Properly classifying and accounting for these leases is crucial for financial reporting under IFRS 16 (International Financial Reporting Standards) and ASC 842 (U.S. GAAP).

1️⃣ Understanding Leases: What Are They?

A lease is a contractual agreement where one party (lessee) pays another party (lessor) for the right to use an asset for a specified period.

A. Operating Lease (Rental Agreement)

✔ The lessee does not own the asset.
✔ Payments are treated as rental expenses on the income statement.
✔ No asset or liability is recorded on the balance sheet (under old rules).

Example: Renting office space for 3 years.

B. Capital Lease (Finance Lease) - Similar to Ownership

✔ The lessee treats the leased asset as if it were purchased.
✔ The lease obligation is recorded as a liability on the balance sheet.
✔ The lessee records depreciation on the asset and interest expense on the lease liability.

Example: Leasing machinery for 10 years with an option to purchase at the end.

2️⃣ Key Criteria for Capital Lease (Finance Lease) Under IFRS & GAAP

Under IFRS 16, all leases (except short-term leases) are considered finance leases and recorded on the balance sheet.

Under ASC 842 (GAAP), a lease is classified as a finance lease if it meets any of these criteria:

✅ The lease transfers ownership of the asset to the lessee at the end.
✅ The lessee has a bargain purchase option (e.g., buy the asset for $1 at the end).
✅ The lease term covers 75% or more of the asset’s useful life.
✅ The present value of lease payments is 90% or more of the asset’s fair value.

If none of these conditions are met, it is an operating lease.

3️⃣ Accounting for Operating Leases (Under IFRS 16 & ASC 842)

🔹 Balance Sheet:

• Under old GAAP, no liability was recorded.
  
  

• Under new rules (IFRS 16 & ASC 842), an asset (Right-of-Use Asset) and a liability (Lease Liability) are recorded.
  
  

🔹 Income Statement:

• Lease payments are recorded as an expense on a straight-line basis.
  
  

🔹 Journal Entry Example (Yearly Lease Payment of $10,000):

Operating Lease Expense     $10,000  

      Cash                              $10,000  

4️⃣ Accounting for Finance (Capital) Leases

🔹 Balance Sheet:

• The leased asset is recorded as a Right-of-Use Asset.
  
  

• The lease obligation is recorded as a liability (similar to debt).
  
  

🔹 Income Statement:

• Depreciation expense on the leased asset.
  
  

• Interest expense on the lease liability.
  
  

🔹 Journal Entry at Lease Inception (Asset Worth $50,000, 5-Year Lease):

Right-of-Use Asset       $50,000  

      Lease Liability                 $50,000  

🔹 Monthly Lease Payment of $1,000 (First Year): 

Lease Liability                     $1,000  

      Cash                                    $1,000  

Interest Expense                   $500  

      Lease Liability                      $500  

Depreciation Expense             $10,000  

      Accumulated Depreciation     $10,000  

5️⃣ Impact on Financial Statements 

6️⃣ Real-World Examples of Lease Accounting

🔹 Airlines (e.g., Delta, American Airlines): Lease planes instead of purchasing them, recording billions in lease liabilities.
🔹 Retail Chains (e.g., Walmart, Starbucks): Lease store locations instead of buying real estate.
🔹 Technology Companies (e.g., Apple, Microsoft): Lease office space and data centers.

7️⃣ Key Takeaways

✅ Operating Leases → Used for short-term asset use, now recorded on the balance sheet.
✅ Finance Leases → Treated like asset purchases, affecting debt ratios and profitability.
✅ IFRS 16 requires all leases to be capitalized, except for short-term or low-value leases.
✅ GAAP still differentiates between finance and operating leases, but both require balance sheet recognition.
✅ Leasing decisions affect key financial ratios, such as the Debt-to-Equity Ratio and EBITDA.