The Difference Between Finance and Operating Leases

The Financial Accounting Standards Board changed lease accounting forever when they implemented the ASC 842 new lease accounting standard.

ASC 842, which replaces the previous GAAP standard ASC 840, changes the way leases are classified and recognized, impacting how lease accounting is executed. Before the alteration, leases were either capital or operating leases; with the new standard, capital leases are now called finance leases. However, the accounting calculations for capital-now-finance leases have remained the same. Operating leases, in contrast, are still the same by name but are recognized in a different way.

Understanding the differences between finance leases and operating leases will allow you to identify which is which and classify it properly for your records.

Finance leases vs operating leases

As stated above, finance and capital leases are nearly the same in everything but name. Leases are classified as ‘finance’ when they have characteristics that make them similar to a purchase of the underlying asset. There are five criteria to consider, any one of which will result in a lease being classified as ‘finance.’

For example, if the total lease payments are substantially all of the leased asset’s fair value, or the lease term is a major part of the leased asset’s economic life, that will be a finance lease. Finance leases then have imputed interest and are amortized over the life of the lease.

Operating leases are lease contracts where the terms do not mimic a purchase of the underlying asset. For example, there is no ownership transfer at the end of the lease and the leased asset could be used by someone else after the lease has ended. In other words, when none of the five-criterion used to classify a lease are true, then you have an operating lease.

Operating leases are used for the limited-term leasing of assets and include traditional renting relationships. Before the new lease accounting standards, these types of leases were expensed and the leased asset and the liabilities associated with it were not included on the balance sheet. Now, regardless of whether a lease is operating or finance, an asset and liability must be recorded on the financial statements.

Example of a finance lease

The previous lease standard considered four “bright line” rules when classifying a lease as capital vs. operating. These rules were clear, but inflexible and could result in calculations that did not make sense for a particular organization. Under the new lease standard, these criteria have been updated to allow organizations more flexibility and judgment when classifying a lease. To be classified as a finance lease, at least one of the following criteria must be true:

• A transferal of ownership of an asset to the lessee at the end of the term of the initial lease.
• The lessee is reasonably certain that they will exercise a purchase option at the end of the term of the lease.
• The leased asset has no alternative use to the lessor at the end of the lease.
• The lease term is a major part of the economic life of the underlying asset (75% was the previous common bright line test number, and most organizations continue to use this to determine “major part”).
• The present value of lease payments is substantially all of the fair value of the leased asset (90% was the previous bright line test number, and most organizations continue to use this to determine “substantially all”).

Once you understand the criteria for qualifying a finance lease, follow the same criteria, if it does not qualify as a finance lease, it is an operating lease.

Comparing finance and operating leases

Leases allow organizations to “pay as they go” for the use of a needed asset without the burden of ownership and often limited maintenance responsibilities. That is a quintessential aspect and advantage of a lease agreement; a lessee gets the benefits of an asset without having to own that asset, and a lessor gets to turn a profit on their asset.

However, all types of leases were not always recorded on the lease balance sheet. Many companies used to prefer to classify their leases as operating leases precisely because they were only recorded on their income statement— they used to have no impact on a company’s balance sheet.

As a result, operating leases did not impact a company’s debt-to-equity ratio because no liabilities were included on the balance sheet with the lease. The ability to leave a lease off of a balance sheet could make a company appear as though they were a better investment and had stronger financials than if the lease was classified as a finance lease.

The fact that operating leases were not documented on a firm’s balance sheet was a loophole that U.S. companies had been using for years to improve their debt-to-equity ratios and other similar metrics frequently used by banks to determine loan covenants. Now, with ASC 842, both types of leases are required to be put on a company’s balance sheet, eliminating the loophole.

However, the expense recognition pattern does differ for operating and finance leases. Operating lease accounting requires lease expenses to be recognized on a straight-line basis over the lease term, whereas finance leases (just like capital leases) require the lessee to recognize interest expense and amortization expense, which means expenses will be higher at the beginning of the lease and decrease over time.

Journal entries for operating leases

ASC 842 is a game-changer for lease accounting for U.S. businesses. While the concepts of operating vs finance leases remain, any lease 12 months or longer is now required to be recorded on a balance sheet. This makes operating lease accounting more complicated for many.

With the new lease standard, operating lease initial journal entries will record a lease liability and right-of-use (ROU) asset onto the balance sheet. Ongoing operating lease journal entries will record a lease expense as usual, as well as reducing the lease liability and ROU asset balance over the life of the lease.

Operating leases used to not be documented on balance sheets, which is why U.S. firms often classified as many leases as possible as an operating lease. Now, under ASC 842, these leases are included on the balance sheet.

Utilize software to help with lease accounting

With the changes in lease documentation and the requirement of all leases to be documented on balance sheets, looking for methods and tools to ease into these new changes and make sure your company’s lease accounting is up to the new standards is a good strategy.

Our lease accounting specialists have implemented Leasecrunch to help with the transition to the new lease accounting standard for numerous clients with great results. For more insightful information on lease accounting and compliance, visit LeaseCrunch. LeaseCrunch offers expert guidance and solutions to simplify lease accounting, ensuring you stay up-to-date with the latest standards.