What is the difference between an operating lease and a finance (capital) lease?

Under old standards, operating leases were rentals while finance leases were essentially purchases. Under IFRS 16/ASC 842, most leases are now treated as finance leases for lessees.

Operating Lease vs Finance Lease

Leases are classified as either operating or finance (capital) leases based on whether risks and rewards of ownership transfer to the lessee.

Old Standards (pre-2019):

Operating Lease: Rental arrangement
Finance Lease: Essentially a purchase
Different accounting for each type

New Standards (IFRS 16/ASC 842):

Most leases treated as finance leases for lessees
Operating lease treatment eliminated for lessees
Lessor accounting largely unchanged

Old Standards Comparison

Operating Lease (Old Rules):

Short-term rental, lessee doesn't assume ownership risks.

Accounting: Lease payments as rent expense
Balance Sheet: No asset or liability
Example: Office space rental for 3 years
Journal Entry: Dr Rent Expense, Cr Cash

Finance/Capital Lease (Old Rules):

Long-term lease, effectively a purchase.

Accounting: Record asset and liability
Balance Sheet: Asset and loan liability
Example: Equipment lease for 80% of life
Journal Entry at start: Dr Equipment, Cr Lease Liability
Journal Entry each period: Dr Interest Expense, Dr Lease Liability, Cr Cash

Old Classification Criteria (IAS 17):

Finance lease if ANY of these apply:

Ownership transfers at end of lease
Bargain purchase option exists
Lease term ≥ 75% of asset's economic life
Present value of payments ≥ 90% of asset's fair value
Asset specialized for lessee

If none apply → Operating lease

New Standards (IFRS 16/ASC 842)

Key Changes:

Effective dates: IFRS 16 (2019), ASC 842 (2022 for public companies)
Lessee accounting: All leases (except short-term/low-value) are finance leases
Lessor accounting: Similar to old standards
Purpose: Bring leases onto balance sheet

New Lessee Accounting:

For all leases (except exemptions):

Record Right-of-Use (ROU) asset
Record lease liability at present value of payments
Depreciate ROU asset over lease term
Recognize interest expense on liability

Example - Office Lease under IFRS 16:

5-year office lease, annual payments $20,000
Interest rate: 5%
Present value of payments: $86,590
At commencement:
- Dr ROU Asset $86,590
- Cr Lease Liability $86,590
Year 1 payment:
- Dr Interest Expense $4,330 (5% × $86,590)
- Dr Lease Liability $15,670
- Cr Cash $20,000
Year 1 depreciation:
- Dr Depreciation Expense $17,318 ($86,590 ÷ 5)
- Cr Accumulated Depreciation - ROU $17,318

Exemptions (Still Operating Lease Treatment):

Short-term leases: ≤ 12 months
Low-value assets: Below company's materiality threshold (e.g., $5,000)

Financial Statement Impact - New vs Old:

Aspect	Old Standards	New Standards
Assets	Operating: None Finance: Asset recorded	ROU asset for all leases
Liabilities	Operating: None Finance: Liability recorded	Lease liability for all leases
Income Statement	Operating: Rent expense Finance: Depreciation + interest	Depreciation + interest for all
EBITDA	Operating: Lower (rent expense) Finance: Higher	Higher for all leases
Debt Ratios	Operating: Better Finance: Worse	Worse for all companies

Practical Implications:

For Lessees:

Increased assets and liabilities on balance sheet
Higher EBITDA (rent expense removed)
Worse debt/equity ratios
More complex accounting
Need to track all leases systematically

For Lessors:

Similar to old standards
Still classify as operating or finance lease
Finance lease: Recognize receivable, derecognize asset
Operating lease: Keep asset, recognize rental income

Key Differences Summary:

Feature	Operating Lease (Old)	Finance Lease (Old)	All Leases (New)
Asset on B/S	No	Yes	Yes (ROU asset)
Liability on B/S	No	Yes	Yes
Expense Pattern	Straight-line rent	Depreciation + interest	Depreciation + interest
Ownership Risk	Lessor	Lessee	Depends on terms
Tax Treatment	Rent deduction	Depreciation + interest	Depends on tax rules

Important Notes:

New standards apply prospectively (existing leases recognized)
Transition requires significant effort for companies with many leases
Software often needed to calculate present values and track leases
Disclosure requirements increased significantly
Companies may try to structure leases to qualify for exemptions
Auditors focus heavily on lease accounting under new standards

Key Points to Remember:

Old standards: Two different treatments based on classification
New standards: Most leases on balance sheet for lessees
ROU asset = right to use asset, not ownership
Lease liability = present value of future payments
Exemptions exist for short-term and low-value leases
Lessor accounting largely unchanged