What’s the difference between capital leases and operating leases?

Operating leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as operating expenses on the Income Statement.

Capital leases are used for longer-term items and give the lessee ownership rights; they depreciate and incur interest payments, and are counted as debt.

A lease is a capital lease if any one of the following 4 conditions is true:

1. If there’s a transfer of ownership at the end of the term.

2. If there’s an option to purchase the asset at a bargain price at the end of the term.

3. If the term of the lease is greater than 75% of the useful life of the asset.

4. If the present value of the lease payments is greater than 90% of the asset’s fair market value.