Depending on the country you live in and the related tax jurisdiction, the definition of operating and capital leases can vary for accounting and income tax purposes.
In Canada, an overview of the related definitions are as follows (check with your accountant for a more detailed review of the rules and related interpretations).
For a capital lease, the equipment is expected to be financed for most of its useful life and there is a reasonable expectation in place that the lessee will purchase the equipment outright from the lessor at the end of the lease term.
An operating lease is basically the opposite in that the equipment is leased for less of the useful life of the asset and at the end of the lease term, the lessee can return the asset to the lessor with no further obligation.
From an accounting point of view, the assessment of capital versus operating lease is done by applying the following four rules to a leasing transaction. If any of these four rules apply, the underlying lease is a capital lease.
First, does the lease term represent more than 75% of the equipments projected useful life?
Second, does the lease provide the lessee with an option to purchase the equipment at an amount less than its fair market value?
Third, will the ownership of the equipment be transferred to the lessee at the expiration of the lease term?
Fourth, is the net present value of all the lease payments greater than 90% of the fair market value of the equipment?
If the answer to all of the four questions is NO, then the lease is an operating lease.
A capital lease ends up being accounted for on your financial statements much like an asset purchase in that the leased item has to be set up as an asset and depreciated over time while the lease needs to be shown as a liability with the interest portion recorded as an expense for tax purposes.
Operating leases are not listed on the balance sheet (they may be listed in the notes) and the related payments are recorded as an operating expense.
Unless the business has no intended future use for an asset after the financing period, the resulting financing tends to be in the form of a capital lease.
Capital leases also tend to be lower in what we’ll call the net effective costs associated with the lease as there is no risk premium built in by the lessor for asset disposition at the end of the lease term.
Operating leases are more suited to assets that either wear out quickly from heavy use or are rapidly replaced in the market by newer technology.