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Operating lease is a term used mostly in accounting to denote a lease that gives the lessee rights to use and operate an asset without ownership. An operating lease is different from a capital or financing lease, which is more of a financed sale of the asset.

Accounting guidelines contain multiple rules to differentiate between an operating lease and a capital lease. Generally, a capital lease is non-cancellable. Also, in order to be a capital lease, the lease terms must contain one of the following: be for 75% the asset’s useful life, the payments are 90% of the value of the leased asset, or the lease contains a bargain purchase option.

The distinction between operating lease versus capital lease has an impact on a company’s financial statements. 

A capital lease is recorded as a liability, and the leased asset becomes a depreciable asset on the company’s balance sheet. Lease payments are booked as loan payments and do not impact the income statement.

In contrast, an operating lease is not recorded anywhere on the company’s balance sheet.  Lease payments are booked as rent expense.  Even though the lease becomes an obligation of the company, because they are not recorded on the company’s balance sheet, operating leases are often referred to as “off balance sheet financing.” 

The Internal Revenue Code contains similar rules. The IRS may reclassify an operating lease as a capital lease to deny the lease payments as a deduction, thus raising taxable income and ultimately the taxpayer’s tax liability.

 

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