Capital Lease vs Operating Lease Explained | CPA FAR Guide
Capital vs Operating Lease: Key Differences Guide
The terms capital lease and operating lease describe two fundamentally different ways of accounting for lease agreements. Under the legacy US GAAP standard (ASC 840), a capital lease transferred substantially all risks and rewards of ownership to the lessee and was recorded on the balance sheet, while an operating lease was treated as a rental expense. With the introduction of ASC 842, all leases longer than 12 months now appear on the balance sheet, but the distinction between finance leases (formerly capital leases) and operating leases remains critical for expense recognition.
- Under ASC 842, "capital lease" is now called a "finance lease" but the concept is the same
- Both finance and operating leases are recognised on the balance sheet under ASC 842
- Finance leases have front-loaded expenses (amortisation + interest); operating leases have straight-line expense
- The classification test uses five criteria — meeting any one makes it a finance lease
- IFRS 16 treats nearly all leases as finance leases, eliminating the operating lease category for lessees
Table of Contents
- What Is a Capital (Finance) Lease?
- What Is an Operating Lease?
- Lease Classification Criteria (ASC 842)
- Side-by-Side Comparison
- Worked Example With Journal Entries
- Balance Sheet and Income Statement Impact
- IFRS 16 vs ASC 842
- Common Mistakes to Avoid
- Quick Glossary
- FAQ
- CPA FAR Exam Tips
What Is a Capital (Finance) Lease?
A capital lease — now called a finance lease under ASC 842 — is a lease that transfers substantially all the risks and rewards of ownership from the lessor to the lessee. The lessee records both a right-of-use (ROU) asset and a lease liability on the balance sheet.
Expense recognition is front-loaded: the lessee records amortisation of the ROU asset and interest expense on the lease liability separately. This results in higher total expense in the early years of the lease term.
Plain-English Example: A company leases equipment for 8 years when the equipment's useful life is 10 years. The lease includes a bargain purchase option at the end. This is a finance lease because ownership effectively transfers.
What Is an Operating Lease?
An operating lease is a lease where the lessor retains most of the risks and rewards of ownership. Under ASC 842, operating leases are also recorded on the balance sheet with an ROU asset and lease liability, but expense recognition differs significantly.
The lessee recognises a single straight-line lease expense over the lease term. There is no separate amortisation or interest charge on the income statement, resulting in a more even expense pattern.
Plain-English Example: A company leases office space for 3 years with no purchase option and no transfer of ownership. The lease term is well below the building's remaining useful life. This is an operating lease.
Lease Classification Criteria (ASC 842)
Under ASC 842, a lease is classified as a finance lease if it meets any one of the following five criteria. If none are met, it is an operating lease:
| # | Criterion | Test |
| 1 | Transfer of ownership | Ownership transfers to the lessee by the end of the lease term |
| 2 | Purchase option | Lessee has an option to purchase that is reasonably certain to be exercised |
| 3 | Lease term | Lease term is for the major part of the asset's remaining economic life (typically ≥75%) |
| 4 | Present value | PV of lease payments equals or exceeds substantially all of the asset's fair value (typically ≥90%) |
| 5 | Specialised asset | The asset is so specialised that it has no alternative use to the lessor after the lease term |
Exam Tip: Remember the mnemonic TOWPS — Transfer, Option, Written (major part), Present value, Specialised. Under ASC 840, the thresholds were bright-line (75% and 90%); under ASC 842, they are guidelines rather than rigid rules.
Side-by-Side Comparison: Finance Lease vs Operating Lease
| Feature | Finance Lease (Capital Lease) | Operating Lease |
| Balance sheet | ROU asset + lease liability | ROU asset + lease liability |
| Income statement | Amortisation expense + interest expense (separately) | Single straight-line lease expense |
| Expense pattern | Front-loaded (higher in early years) | Even (straight-line over lease term) |
| Cash flow statement | Principal: financing; Interest: operating or financing | All payments: operating |
| ROU asset amortisation | Similar to owned assets (straight-line or other systematic method) | Derived as plug (lease expense minus interest) |
| Ownership transfer | Likely or certain | Not expected |
| Total expense over lease term | Same total as operating lease | Same total as finance lease |
Worked Example: Finance Lease vs Operating Lease
Scenario: RetailCo leases equipment with a fair value of $100,000. Lease term is 5 years with annual payments of $23,000 made at the end of each year. The lessee's incremental borrowing rate is 6%. The equipment has a useful life of 7 years. No transfer of ownership or purchase option exists.
Classification Test
- Transfer of ownership? No
- Purchase option reasonably certain? No
- Lease term ≥75% of useful life? 5/7 = 71% — No (but close)
- PV of payments ≥90% of fair value? PV = $23,000 × 4.2124 = $96,885 — 97% of $100,000 — Yes
- Specialised asset? No
Result: Criterion 4 is met, so this is a finance lease.
Initial Recognition (Both Lease Types)
Dr Right-of-Use Asset $96,885
Cr Lease Liability $96,885
Year 1: Finance Lease Entries
| Entry | Debit | Credit |
| Interest expense (6% × $96,885) | $5,813 | |
| Lease liability (payment minus interest) | $17,187 | |
| Cash | $23,000 | |
| Amortisation expense ($96,885 / 5 years) | $19,377 | |
| Accumulated amortisation | $19,377 |
Year 1 total expense (finance lease): $5,813 + $19,377 = $25,190
Year 1: Operating Lease Entry
If this were an operating lease, the entry would be:
Dr Lease Expense $23,000 (straight-line: $115,000 total payments / 5 years)
Dr Lease Liability $17,187
Cr ROU Asset $17,187
Cr Cash $23,000
Year 1 total expense (operating lease): $23,000 (straight-line)
Note: The finance lease produces higher expense ($25,190) in Year 1 compared to the operating lease ($23,000), but total expense over the full 5-year term is the same for both.
Balance Sheet and Income Statement Impact
| Financial Statement | Finance Lease | Operating Lease |
| Assets | ROU asset (amortised like owned asset) | ROU asset (reduced by difference between lease expense and interest) |
| Liabilities | Lease liability (effective interest method) | Lease liability (effective interest method) |
| Operating income | Reduced by amortisation only (interest is below the line) | Reduced by full lease expense |
| EBITDA | Higher (amortisation and interest excluded) | Higher (lease expense excluded from some EBITDA definitions) |
| Net income (early years) | Lower (front-loaded expense) | Higher (straight-line expense) |
IFRS 16 vs ASC 842
| Feature | ASC 842 (US GAAP) | IFRS 16 |
| Lease classification | Finance lease vs operating lease | Single model — all leases treated like finance leases |
| Operating lease on balance sheet | Yes (ROU asset + lease liability) | No operating lease category for lessees |
| Expense pattern for lessee | Finance: front-loaded; Operating: straight-line | All leases: front-loaded (amortisation + interest) |
| Short-term lease exemption | Leases ≤12 months | Leases ≤12 months |
| Low-value asset exemption | Not available | Available (e.g., laptops, small office equipment) |
For deeper IFRS guidance on lease accounting under IFRS 16, explore our DipIFR coaching programme.
Common Mistakes to Avoid
- Using old terminology on the exam: ASC 842 uses "finance lease" not "capital lease" — but the exam may use both terms interchangeably
- Forgetting both lease types are on the balance sheet: Under ASC 842, operating leases also create ROU assets and lease liabilities
- Mixing up expense patterns: Finance = front-loaded (amortisation + interest); Operating = straight-line single expense
- Applying bright-line tests rigidly: ASC 842 uses 75% and 90% as guidelines, not absolute thresholds (unlike ASC 840)
- Confusing ASC 842 with IFRS 16: IFRS 16 has no operating lease category for lessees; all leases are finance-type
- Ignoring short-term lease exemption: Leases of 12 months or less can be excluded from balance sheet recognition
Quick Glossary
| Term | Plain-English Definition |
| Capital Lease | Legacy term (ASC 840) for a finance lease; transfers ownership risks to lessee |
| Finance Lease | Current term (ASC 842) for a lease that transfers substantially all risks and rewards |
| Operating Lease | A lease where the lessor retains most risks; straight-line expense under ASC 842 |
| ROU Asset | Right-of-use asset — the lessee's right to use the leased asset over the lease term |
| Lease Liability | Present value of remaining lease payments owed by the lessee |
| Incremental Borrowing Rate | Rate the lessee would pay to borrow funds on a similar basis; used to discount lease payments |
| Implicit Rate | Rate that makes PV of lease payments plus residual value equal the asset's fair value |
Frequently Asked Questions
What is the difference between a capital lease and an operating lease?
A capital lease (now called a finance lease under ASC 842) transfers substantially all risks and rewards of ownership to the lessee, while an operating lease does not. The key accounting difference is expense recognition: finance leases have front-loaded expenses (separate amortisation and interest), while operating leases have a single straight-line expense. Under ASC 842, both types appear on the balance sheet.
Is a capital lease the same as a finance lease?
Yes. When ASC 842 replaced ASC 840, the term "capital lease" was renamed to "finance lease." The underlying concept is the same: a lease that effectively transfers ownership. The CPA exam may use either term, so candidates should be familiar with both.
Do operating leases go on the balance sheet under ASC 842?
Yes. This was one of the biggest changes introduced by ASC 842. Previously under ASC 840, operating leases were off-balance-sheet. Now, lessees must recognise a right-of-use asset and a lease liability for all leases with terms greater than 12 months, including operating leases.
How do you classify a lease under ASC 842?
A lease is classified as a finance lease if it meets any one of five criteria: transfer of ownership, purchase option reasonably certain to be exercised, lease term for major part of useful life (guideline: 75%), present value of payments substantially all of fair value (guideline: 90%), or the asset is so specialised it has no alternative use to the lessor. If none are met, it is an operating lease.
Why does a finance lease have higher expense in early years?
A finance lease separates expense into amortisation (straight-line) and interest (calculated on the declining lease liability balance). In early years, the lease liability is higher, so interest expense is higher. Combined with constant amortisation, total expense is front-loaded. An operating lease, by contrast, recognises a single straight-line expense that stays constant each period.
How does IFRS 16 treat operating leases differently from ASC 842?
Unlike ASC 842, IFRS 16 does not maintain a separate operating lease category for lessees. Under IFRS 16, virtually all leases are accounted for as finance leases, with the lessee recognising amortisation and interest expense separately. This means all lessee expenses under IFRS 16 are front-loaded, whereas ASC 842 allows straight-line expense for operating leases.
CPA FAR Exam: How Lease Classification Is Tested
| Exam Focus Area | What to Know |
| Classification criteria | Five criteria (TOWPS); meeting any one = finance lease |
| Journal entries | Initial recognition, payment entries, and amortisation for both lease types |
| Expense comparison | Front-loaded (finance) vs straight-line (operating); same total over lease term |
| Balance sheet impact | Both types create ROU asset and lease liability; ROU asset amortisation differs |
| Cash flow classification | Finance: principal in financing, interest in operating; Operating: all in operating |
| IFRS differences | IFRS 16 single model vs ASC 842 dual model; no operating lease category under IFRS for lessees |
Also see our related CPA FAR guides on ASC 842 Lease Accounting, Goodwill Impairment Test, and Deferred Tax Assets (ASC 740).
Ready to Pass CPA FAR?
Master lease classification and every other FAR topic with structured CPA review materials.
Explore Surgent CPA Review Explore DipIFR Coaching
About the Author
Vicky Sarin is the founder of Eduyush, a professional certification coaching platform. With years of experience in accounting education, Vicky helps CPA, ACCA, and DipIFR candidates master complex topics through clear, exam-focused content. Connect with Eduyush for CPA review courses and DipIFR coaching.
Leave a comment