Which statement correctly describes a capital lease compared to an operating lease?

• A. Capital leases are longer-term items with ownership rights and are depreciated and incur interest expense as debt
• B. Operating leases are always recorded as assets and liabilities on the balance sheet
• C. Capital leases do not affect interest expense
• D. Operating leases show up as depreciation on the income statement

Answer: (A)

The concept being tested is how a finance (capital) lease compares to an operating lease in terms of balance sheet and income statement treatment. A capital lease is treated as a financed purchase: the lessee records the asset and a lease liability on the balance sheet. Over time the asset is depreciated, and interest expense is recognized on the lease liability, with principal payments reducing the liability. This mirrors owning the asset and borrowing to finance it, so it’s described as longer-term with ownership rights and as incurring both depreciation and interest expense.

Other statements don’t fit that treatment. Operating leases historically weren’t on the balance sheet (they were expensed as rent), so saying they’re always recorded as assets and liabilities is inaccurate in traditional accounting. Capital leases do affect interest expense, so claiming there’s no interest is incorrect. And operating leases don’t show depreciation on the income statement; lease payments are treated as operating expenses rather than depreciation.