What is the difference between Capital and Operating leases?

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What is the difference between Capital and Operating leases?


Capital leases

• These are long term contracts signed by the company to use certain PP&E over several years in return for payments to the owner (lessor) of the PP&E.


• Although companies are leasing the assets, capital leases treat these contracts as if the company owns the assets and adds it to the balance sheet.


• The assets are depreciated over its useful life and lease payments or rental payments are treated as a liability almost like debt obligations.


Operating leases

• Unlike capital leases which treats the PP&E as if the company purchased it, operating leases sees the company recording no assets on its balance sheet.


• The operating lease payments or rental payments hit the income statement directly.


• On the balance sheet cash goes down by the lease payments and equity reduces by the same amount through retained earnings.


• Many analysts treat operating leases as off-balance sheet financing and will convert them to capital leases to compare apples to apples with other companies in the sector which treat their leases as capital leases.