Capital Lease

Businesses often require financial support to sustain their daily operations, and leasing is an effective way to manage these finances. One major advantage of leasing is that it eliminates the need for upfront asset payments while granting access to higher-quality equipment. There are two main types of leases: capital leases and operating leases, each with distinct structures, accounting treatments, and tax implications.

Table of Contents

What is a capital lease?
What can be leased?
Why do companies lease?
The four criteria of a capital lease
Capital lease versus operating lease
Pros and cons of leasing
Accounting treatment of capital lease
Frequently Asked Questions

What is a capital lease?

A capital lease is the lease of any business equipment or property by a lessor to a lessee. The lessor agrees to transfer ownership of the asset to the lessee once the lease period is over.

Leasing is different from buying. When you buy an asset, you take ownership of it upon payment. When you lease an asset, you pay leasing fees but don’t own the property yet.

In a capital lease, ownership is passed to the lessee on completion of the lease period. The lease acts like a loan for the asset by the lessor to the lessee and is considered part of the lessee’s debt.

What can be leased?

Assets that are typically leased include aircraft, land, buildings, vehicles, heavy equipment, ships etc.

Why do companies lease?

Leasing is a common alternative to purchasing. When companies have limited funds to purchase an asset, they may lease.

The four criteria of a capital lease

To be classified as a capital lease under US Generally Accepted Accounting Principles or US GAAP, any one of the following four conditions must be met:

Transfer of ownership of the asset at the end of the term

Option to purchase the asset at a discounted price at the end of the term

Term of the lease is greater than or equal to 75% of the useful life of the asset

Present value of the lease payments is greater than or equal to 90% of the asset’s fair market value

Capital lease versus operating lease

There are two kinds of leases: capital lease and operating lease. Each is used for different purposes and is treated differently in accounting.

An operating lease is an agreement to use and operate an asset without the transfer of ownership. It is like renting, while capital leases are considered purchases.

As such, leasing payments under an operating lease are booked as operational expenses and the asset stays off the lessee’s balance sheet. In contrast, a capital lease is more like a loan. The asset is treated as being owned by the lessee, so it stays on the lessee’s balance sheet.

Capital leases are usually used for long-term leases and for items that don’t become obsolete very fast, such as machinery.

Operating leases, sometimes called service leases, tend to be used for short-term leasing of less than a year. They are often used for high-tech assets or when technology changes quickly, like computers and office equipment. Businesses with operating leases likely don’t wish to keep the assets over the long term.

Pros and cons of leasing

Pros:

Businesses that lease do not need to get a loan or tie up their funds to buy assets. Leases thus add flexibility to their businesses.

A lessee can claim depreciation deductions, reducing its taxable income. Interest expense deductions can also reduce its taxable income.

Cons:

Risk of obsolescence. There is a risk the lessee will be stuck with obsolete assets during the lease.

Maintenance responsibilities. The lessee must bear all asset repair and maintenance costs during the lease period.

Accounting treatment of capital lease

A capital lease transfers asset ownership to the lessee at the end of the lease term, functioning similarly to a loan. Interest payments are recorded as expenses on the income statement, while the asset appears on the lessee’s balance sheet, with its current market value listed as an asset and the remaining loan amount as a liability.

In contrast, an operating lease treats lease payments as operating expenses on the income statement. Since the lessee does not gain ownership, the asset is excluded from the balance sheet, and no depreciation is recorded for it, keeping the asset off the company’s financial statements.

Frequently Asked Questions

Which is better - capital lease or operating lease?

It depends.

The advantages of a capital lease include:

The lessee is allowed to claim depreciation on the asset, which reduces its taxable income

Interest expense also reduces its taxable income

The advantages of an operating lease include:

Operating leases provide greater flexibility to companies as they can replace or update their equipment more often

No risk of obsolescence, as there is no transfer of ownership

Accounting for an operating lease is simpler

Lease payments are tax-deductible

Is capital lease a debt?

When a lease is categorized as a capital lease, the present value of the lease payments is recorded as debt. Interest is then calculated on this amount and reflected in the income statement as part of the lessee’s financial obligations.

Is capital lease a capex?

Capital Expenditures (Capex) or Capital Leases refer to the expenses a borrower incurs within a specified timeframe for capital investments and payments related to capital leases.

What is an example of a capital lease?

An example of a capital lease is when a business leases equipment. In this scenario, the equipment is recorded as an asset on the lessee’s balance sheet, while the corresponding obligation is noted as a capital lease liability.

What is the 90% rule in leasing?

The 90% rule is a key criterion for distinguishing between operating and finance leases. If the present value of future lease payments equals 90% or more of the fair value of the leased asset, the lease is classified as a finance lease rather than an operating lease.