Major differences between Capital Leases and Operating Leases in CFA Level 1

Capital Leases and Operating Leases often come up as complicated concepts to master for CFA Level 1 candidates (especially for candidates who do not have an accounting background). In this article we want to explore and hopefully clarify these concepts.

In its simplest form, a lease is a contractual agreement between a lessor and a lessee that gives the lessee the right to use a specific property, owned by the lessor, for a specified period of time in return for a stipulated, and generally periodic, cash payments.

A simple example is You (the lessee) decide to lease a car from the Dealership (the lessor) for 3 years.

Advantages of leasing:

  • Provides 100% financing at a fixed rate
  • Protects against obsolescence
  • More flexible than other debt agreements
  • Less costly financing for lessee and provides tax incentives for the lessor
  • Off-balance-sheet financing

Accounting by lessees

All leases from the lessee’s standpoint are classified as either an operating or a capital lease. Since an operating is not included in assets and liabilities on the balance sheet, it is a form of off-balance-sheet financing.  The following diagram shows the three conditions that must be satisfied for the lessee to classify the lease as an operating lease:

Operating Lease

Although these criteria pertain to U.S. GAAP, IFRS have similar criteria but less specific.

Reporting of:

Operating lease: 

  1. Balance sheet is not affected.
  2. Rent expense equal to lease payment is recognized on the income statement.
  3. The lease payment is reported on the cash flow statement in cash flow from operating activities.


Capital (finance) lease:

  1. The lower of present value of lease payment or fair value of leased asset is recognized as both an asset and liability on the balance sheet.
  2. Asset is depreciated and both depreciation expense and interest expense is recognized on the income statement. Interest expense = lease liability X lease interest rate
  3. On the cash flow statement, the lease payment is separated into interest and principal components. The interest goes in the cash flow from operating activities and the principal in financing activities.

The following tables summarizes the impact of the two types of leases on financial statements and key ratios

Impact Summary of Capital versus Financial Lease

As a suggestion to help you better remember these different impacts, try to remember the impact for only one of the leases (either the Capital or the Operating), then you’ll know that the other type of lease has the opposite effect on these ratios.

Accounting by lessor

Under IFRS, the accounting by the lessor is the same as the lessee. Under U.S. GAAP the lease can be classified as a operating lease, sales-type lease or direct financing lease:

Financial Lease

Reporting of:


Operating lease: 

  1. Asset is kept on the balance sheet and depreciated.
  2. Lease payments are recognized as rental income.
  3. Full lease payments is classified as cash flow from operating activities


Sales-type lease:

  1. Asset is removed from the balance sheet and a lease receivable is created (present value of payments)
  2. Sale equal to the present value of the asset is recognized on the income statement and cost of goods sold equal to the carrying value. Therefore a gross profit is recognized (sales – COGS)
  3. Interest portion of lease payments is recognized as income and the principal portion reduces the lease receivable.
  4. Interest portion is cash inflow from operating activities while the principal is inflow from investing.


Direct financing lease:

  1. Asset is removed from the balance sheet and a lease receivable is created
  2. Interest portion of lease payments is recognized as income and the principal portion reduces the lease receivable.
  3. Interest portion is cash inflow from operating activities while the principal is inflow from investing.

Capital Leases and Operating Leases do not carry a significant weight in the CFA Level 1 exam. They are more likely to show up in order to test your ability to understand when to use which classification and what effect they have on the financial ratios of a given firm. Its always better to understand these concepts while you’re studying for the Level 1 exam, because Capital and Operating Leases also show up on the Level 2 curriculum, but on a much smaller scale.

We also invite you to check out our latest CFA® Level 1 Starter Kit.

We created this CFA® Level 1 Starter Kit to help you better prepare for the upcoming CFA® exam.

CFA Level 1 - Starter Kit

We want to help you maximize your study efficiency and avoid the most common mistakes candidates make on the CFA ® Level 1 exam.

CFA ®Level 1 Starter Kit includes:

  • Top 100 Pitfalls (mistakes) to avoid on the CFA ® Level 1 exam (+50 pages PDF eBook)
  • Exam Strategies (9 pages PDF article)
  • Concentration Tips (9 page PDF article)
  • 3 study schedules : 16 weeks, 14 weeks and 10 weeks study plans (customizable in Excel)

By using the resources found in this Study Kit, you will be able to better focus on your studies knowing that you will have enough time to cover everything before the exam. You will also the learn the most frequent errors CFA® Level 1 Candidates make and how to avoid them on the exam day.