What is the key difference between operating leases and capital leases?

What is the key difference between operating leases and capital leases?

• A. Operating leases do not involve ownership and are expensed; capital leases are depreciated and counted as debt.
• B. Operating leases create an asset and liability on the balance sheet; capital leases do not.
• C. They are treated identically on financial statements.
• D. Only operating leases require payments.

Answer: (A)

The key difference is whether the lease effectively transfers ownership risks and rewards to the lessee. A capital (finance) lease is treated like a financed purchase: the lessee records both an asset and a liability on the balance sheet, depreciates the asset, and recognizes interest on the liability as payments are made. An operating lease is treated like a rental: lease payments are expensed as they are incurred, and historically no asset or liability is recorded on the balance sheet. So the statement that operating leases are expensed and do not involve ownership, while capital leases involve depreciation and a debt-like liability, best captures this distinction. The other options either reverse the balance-sheet effects, claim identical treatment, or ignore the payment aspect.

The key difference is whether the lease effectively transfers ownership risks and rewards to the lessee. A capital (finance) lease is treated like a financed purchase: the lessee records both an asset and a liability on the balance sheet, depreciates the asset, and recognizes interest on the liability as payments are made. An operating lease is treated like a rental: lease payments are expensed as they are incurred, and historically no asset or liability is recorded on the balance sheet. So the statement that operating leases are expensed and do not involve ownership, while capital leases involve depreciation and a debt-like liability, best captures this distinction. The other options either reverse the balance-sheet effects, claim identical treatment, or ignore the payment aspect.