Capital Lease vs. Operating Lease: Differences Explained

Table of Contents

What’s a Capital Lease?

A capital lease—now referred to as a finance lease under the Financial Accounting Standards Board (FASB)’s ASC 842 guidelines—is essentially a lease where the lessee assumes most of the benefits and risks of ownership. Unlike an operating lease, a capital lease is treated more like a purchase for accounting purposes and appears on the company’s balance sheet as both a fixed asset and a liability.

Here’s how it works: Throughout the lease term, the leased asset is recorded on the lessee’s balance sheet as an asset, while the lease payments are treated like a loan. The lessee also records depreciation expense and interest expense, which affect both the income statement and taxable income. At the end of the lease, the ownership of the asset typically transfers to the lessee, either outright or through a bargain purchase option.

Capital leases are ideal for companies looking to eventually own the asset and are willing to manage the risks of ownership. For example, a biotech company purchasing specialized lab equipment—like a mass spectrometer with a long useful life—might find a capital lease appealing for its ability to claim depreciation and reduce its taxable income.

What’s an Operating Lease?

An operating lease is a lease agreement where the lessee gains the right to use an asset for a specified period of time, but the ownership of the asset remains with the lessor. Unlike a capital lease, an operating lease is treated as a rental for accounting purposes, with lease payments classified as operating expenses on the income statement.

Under the updated GAAP accounting rules outlined in ASC 842, operating leases must now appear on the company’s balance sheet as both a right-of-use asset and a lease liability. This change provides greater transparency in financial statements, ensuring businesses accurately disclose their leasing obligations. However, unlike a capital lease, an operating lease does not involve the transfer of ownership at the end of the lease.

Operating leases are ideal for businesses prioritizing flexibility and low upfront costs. For instance, a biotech lab with evolving equipment needs might prefer an operating lease for short-term access to tools like centrifuges or chromatography systems. This approach avoids the risks of ownership while preserving cash flow, allowing the lab to upgrade equipment as technology advances.

Differences Between Capital Leases & Operating Leases

The distinction between capital leases and operating leases lies in their accounting treatment, financial impact, and how ownership is handled. These differences affect how businesses manage their cash flow, balance sheet, and overall financial strategy.

How to Identify a Capital Lease

A lease is classified as a capital lease if it meets any of the following conditions, as defined by the Financial Accounting Standards Board (FASB):

Ownership of the asset transfers to the lessee at the end of the lease term.
A bargain purchase option allows the lessee to buy the asset for less than its fair market value.
The lease term covers 75% or more of the asset’s useful life.
The present value of the lease payments equals or exceeds 90% of the asset’s fair market value.
The asset is highly specialized and cannot be resold by the lessor after the lease.

If any of these criteria are met, the lease is treated as a purchase for accounting purposes, and the asset is recorded on the lessee’s balance sheet.

How to Identify an Operating Lease

An operating lease, on the other hand, must meet none of the capital lease criteria. This means:

Ownership of the asset does not transfer to the lessee.
The lease does not include a bargain purchase option.
The lease period is shorter than 75% of the asset’s economic life.
The present value of the lease payments is less than 90% of the asset’s fair market value.
The asset can be easily resold or used by the lessor after the lease ends.

Operating leases are designed for businesses that need flexibility and do not want the long-term commitment or risks associated with ownership.

Key Takeaways

Capital leases are best suited for acquiring long-term assets and gaining ownership rights.
Operating leases are ideal for short-term leases or when the goal is to avoid the risks of ownership while preserving cash flow.

What Are the Accounting Differences Between Capital Leases & Operating Leases?

The accounting treatment of capital leases and operating leases varies significantly, influencing how businesses report them on their financial statements, plan for taxes, and manage cash flow. While both lease types are now recognized on the balance sheet under ASC 842, the details differ.

Accounting for Capital Leases

A capital lease, also known as a finance lease, is treated like a purchase. Here’s how it’s accounted for:

Balance sheet: The leased asset is recorded as a fixed asset, and the lease liability is recorded as a long-term debt.
Income statement: Lease payments are divided into depreciation expense (for the asset) and interest expense (for the liability). This accounting treatment reduces taxable income over time.
Depreciation: The leased asset is depreciated over its useful life, following a straight-line method in many cases.
Ownership transfer: At the end of the lease term, ownership of the asset typically transfers to the lessee, either through outright ownership or a bargain purchase option.

Accounting for Operating Leases

An operating lease is treated as a rental agreement with different accounting implications:

Balance sheet: The right-of-use asset and corresponding lease liability are recorded, as required by ASC 842.
Income statement: Lease payments are recorded as operating expenses, which are straight-line over the lease term.
No depreciation: Since the asset is not owned, depreciation is not recorded on the lessee’s financial statements.
Flexibility: Operating leases allow businesses to avoid long-term ownership commitments and the risks of ownership.

Key Differences

Capital leases impact both depreciation and interest expense, while operating leases affect only operating expenses.
With a capital lease, the asset and liability appear on the balance sheet, along with depreciation and interest expenses. For an operating lease, the right-of-use asset and liability are recorded, but only operating expenses affect the income statement.
Capital leases involve eventual ownership, while operating leases focus on temporary use without ownership rights.

For biotech labs or research facilities, the decision between a capital lease and an operating lease depends on whether ownership of the equipment, such as spectrometers or chromatography systems, is a priority. Operating leases can help preserve cash flow for fast-evolving industries, while capital leases are ideal for essential, long-term assets.

The Tax Implications of Capital Leases vs. Operating Leases

The tax treatment and financial benefits of capital leases and operating leases differ significantly. Choosing the right lease type can have a meaningful impact on your company’s taxable income, cash flow, and overall financial strategy.

Tax Benefits of Capital Leases

Depreciation deduction: With a capital lease, the leased asset is treated as if it were purchased. This means the lessee can claim depreciation on the asset, reducing taxable income over its useful life. For businesses with high-value, long-term equipment, this can result in significant tax savings.
Interest deduction: Capital lease payments are split between interest and principal. The interest portion is tax-deductible, offering further financial relief.
Ownership advantage: At the end of the lease term, the lessee typically gains ownership of the asset, enabling the company to add to its fixed asset base and continue benefiting from tax-deductible depreciation.

Tax Benefits of Operating Leases

Operating expense deduction: Operating lease payments are fully tax-deductible as operating expenses on the income statement. This simplifies the accounting process and can provide immediate tax savings.
No ownership risks: Since the asset remains with the lessor, there’s no depreciation to manage or risks tied to ownership of the asset. This can be especially advantageous for companies needing flexibility or planning to upgrade equipment frequently.
Cash flow flexibility: Operating leases typically require lower upfront costs, preserving cash flow for other investments or operational needs.

Which Option Offers the Most Financial Benefits?

The financial benefits depend on your business goals and how you plan to use the leased equipment. For instance:

A biotech startup working with rapidly evolving lab equipment may find operating leases advantageous, as they offer flexibility to upgrade tools like gene sequencers or centrifuges without committing to ownership.
A larger research facility investing in long-term infrastructure may prefer a capital lease to take advantage of depreciation and ownership benefits over time.

The Bottom Line? Both lease types offer valuable tax advantages, but the right choice hinges on your business’s financial strategy, tax planning goals, and equipment needs. Carefully evaluate how each option aligns with your long-term goals and consult with your accountant or financial advisor for guidance.

Which Lease Type Is Best for Your Business?

Deciding between a capital lease and an operating lease requires evaluating your business’s financial goals, cash flow needs, and long-term equipment strategy. Each lease type offers distinct advantages depending on the situation.

When to choose a capital lease

You plan to own the asset: A capital lease is ideal if you want to eventually take ownership of the equipment, adding it to your list of fixed assets.
The asset has a long useful life: If the equipment will remain valuable and productive for many years, a capital lease can be a smart investment.
You want to reduce taxable income: With depreciation and interest expense deductions, a capital lease provides long-term tax benefits.
Your business prioritizes asset-building: Companies focused on growing their asset base, such as a biotech company investing in specialized imaging or sequencing equipment, might benefit from the ownership advantages of a capital lease.

When to choose an operating lease

Flexibility is a priority: Operating leases are perfect for businesses that need to upgrade equipment frequently or avoid long-term ownership commitments.
You want lower upfront costs: Operating leases typically require less capital upfront, preserving cash flow for operational needs or other investments.
Short-term equipment needs: If you only need the equipment for a specific project or a limited period of time, an operating lease is the better choice.
Ownership risks aren’t worth it: For equipment that depreciates quickly or becomes obsolete, such as high-tech lab instruments, operating leases offer a cost-effective solution.

Leasing for Biotechs & Research Facilities

At Excedr, we specialize in providing scientific equipment leasing solutions tailored to the unique needs of life science and biotech companies. These industries face rapidly evolving technology demands, making the choice between a capital lease and an operating lease especially critical.

The right lease type often depends on your lab’s financial strategy and equipment needs. In our experience, operating leases are ideal for labs requiring state-of-the-art instruments—like gene sequencers or spectrometers—that may need frequent upgrades to stay ahead in research.

On the other hand, capital leases are often better suited for durable, high-cost items such as cold storage systems or centrifuges that remain essential for years—think seven to eight years or more.

That said, whether your priority is preserving cash flow or building your asset base, Excedr’s leasing program is designed to help biotech and research organizations thrive by providing access to the tools they need, when they need them.

Finding the Best Leasing Solution for Your Needs

Whether you’re a small business or a large research institution, understanding the differences between a capital lease and an operating lease is key to making informed decisions about your business’s equipment needs. Whether you’re prioritizing flexibility, ownership, or cost management, choosing the right lease type can have a lasting impact on your financial statements and operational strategy.

Capital leases are ideal if your goal is to own the asset, benefit from depreciation and interest deductions, and build your company’s asset base over time.
Operating leases, on the other hand, are perfect for businesses looking to preserve cash flow, avoid the risks of ownership, and maintain the flexibility to upgrade equipment when needed.

For biotech labs and research-intensive organizations, operating leases are often the go-to option for accessing cutting-edge equipment like gene sequencers, chromatography systems, and spectrometers without the long-term commitment of ownership. However, a capital lease may be more appropriate for durable assets with a long useful life, such as cold storage units or essential testing devices.