Definition
A Capital Lease, also known as a finance lease, is a lease agreement in which the lessee acquires most of the risks and rewards associated with ownership of the asset, though the legal title may not be transferred. In financial statements, these leases are recorded as a liability on the lessee’s balance sheet. It is essentially a method of financing an asset where the lessee pays for using the asset over a lengthy period.
Key Takeaways
- A Capital Lease, also known as a finance lease, is an agreement where the lessee has the right to use an asset for most of its useful life, akin to owning it, but it’s technically considered a lease. This kind of lease is effectively a loan which gives the lessee the benefits and drawbacks of ownership.
- For accounting purposes, capital leases are considered as an asset on the company’s balance sheet. They are a form of long-term debt. This is unlike operational leases which are not represented on the balance sheet.
- In a capital lease agreement, the lessee is often responsible for maintenance, insurance, taxes, and other costs associated with the asset. The benefits include claiming depreciation on the asset and interest expenses on the lease liability.
Importance
A Capital Lease is an important finance term because it directly affects a company’s balance sheet.
It’s a lease agreement that gives the lessee the privileges and responsibilities of ownership, essentially blurring the line between lease and purchase.
As a result, the lease is viewed as a de facto purchase, so the lessee must record the leased asset as a fixed asset, and the lease liability as debt on its financial and tax statements.
This will affect important ratios and financial metrics such as debt-to-equity, return on assets, and the firm’s overall leverage, which are crucial for assessing the company’s financial health and stability.
By considering capital leases, both the company and potential investors can gain a more accurate and comprehensive view of the company’s total long-term obligations.
Explanation
A capital lease, also known as a finance lease, is a specific type of lease agreement that serves a significant purpose in the finance field; it essentially falls between leasing an asset and outright owning it. The primary purpose of this financial instrument revolves around enabling businesses or individuals to utilize assets with high cost without needing to commit significant capital for an outright purchase.
This helps especially in maintaining liquidity in a business since such a lease’s structuring allows the lessee to reap the benefits of the asset while also treating it as an owned asset in its financial records. Capital leases are typically used for long term leasing of assets that a company does not intend to replace in the immediate future.
This not only eases the financial burden for high-ticket items but also provides certain benefits, such as tax advantages. For instance, though the asset is technically leased, the lessee can claim depreciation on it, as well as interest expense on the lease payments.
Such a lease is a useful tool for businesses seeking to leverage important assets without bearing the substantial upfront cost of acquisition.
Examples of Capital Lease
Office Equipment: A corporation might enter into a capital lease agreement for high-cost office equipment like photocopiers or high-capacity printers. Suppose a law firm requires a high-capacity printer that costs $20,
Rather than purchasing it outright, the firm leases the printer for a time period long enough that the present value of lease payments constitutes more than 90% of the equipment’s original cost.
Industrial Machinery: Manufacturers often enter into capital lease agreements to acquire heavy machinery. Consider a car manufacturer that needs a new robot assembly line costing $1 million. Due to such high cost, the manufacturer chooses to lease this equipment under a capital lease. Their agreement involves a term that stretches over a significant part of the machinery’s expected lifespan, typically around 75% or more of its useful life.
Real Estate: A company might opt for a capital lease for buildings or land, often due to significant costs associated with outright purchases. For example, a retail company decides to lease a new store location rather than purchase it. According to their lease agreement, the present value of lease payments is about 80% or more of the fair value of the property, making it a capital lease.
Frequently Asked Questions About Capital Lease
What is a Capital Lease?
A Capital Lease, also known as a finance lease, is a long-term lease agreement that allows the lessee to use the leased asset like its own. The lease term usually spans a significant portion of the asset’s useful life.
What is the difference between Capital Lease and Operating Lease?
In a capital lease, the lessee accepts all risks and rewards of property ownership. However, in an operating lease, the lessor retains the risks and rewards associated with the property ownership.
What are the criteria for a lease to be considered a Capital Lease?
A lease is considered a capital lease if it meets any of the following criteria: The lease transfers ownership of the property to the lessee by the end of the lease term; the lease contains a bargain purchase option; the term of the lease is 75% or more of the economic life of the asset; or the present value of the minimum lease payments at the inception of the lease is 90% or more of the market value of the leased asset.
How is a Capital Lease recorded in the financial statements?
Under a capital lease, the lessee records both the leased property as an asset and the lease obligation as a liability in its balance sheet. The lessee also recognizes depreciation expense on the leased asset and interest expense on the lease liability in its income statement.
What are the tax implications of a Capital Lease?
With a capital lease, since the lessee is considered the owner of the asset for accounting purposes, they are able to claim depreciation expense and interest expense on the lease payments as tax deductions.
Related Entrepreneurship Terms
- Lease Agreement
- Depreciation
- Asset Ownership
- Balance Sheet
- Interest Expense
Sources for More Information
- Investopedia: Provides definitions, explanations, and examples on a wide array of finance terms including Capital Lease.
- The Motley Fool: A company that provides financial solutions and advice about various finance terms.
- Accounting Tools: It offers many resources for understanding accounting and finance concepts.
- Corporate Finance Institute: An educational platform focused on financial analyst training. Their resources cover a variety of finance and accounting topics.
