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A Capital lease is a long-term financial agreement where the lessor has agreed that the ownership of the asset will be transferred to the lessee (the company or individual renting the asset) after the completion of the lease period. It allows the lessee the choice of buying an asset at a bargain price than the fair market value after the completion of the lease period. A capital lease is long-term and noncancellable in nature.
Under a capital lease agreement, the lessee records the leased asset on their balance sheet and the lease payments as an interest expense and a liability reduction. A capital lease provides the option to the company of using an asset (such as equipment, machinery, or vehicles) without having to purchase it outright.
It can be beneficial for businesses that need to use the asset but don’t have the cash to buy it upfront. With a capital lease, the business makes regular payments over a set period of time, and at the end of the lease term, it can buy the asset for a nominal amount or return it to the lessor.
If the lease is cancelled for any reason, the lessee will have to bear any resulting loss. At the end of the lease term, the lessee becomes the owner of the asset and can claim finance and depreciation charges. A capital lease can be used for a property as well as an asset.
For example, a manufacturing company can obtain a piece of production machinery for their operations through a capital lease. Companies use capital leases for land, buildings, ships, aircraft, engines, and very heavy machinery.
Let’s take a manufacturing company as an example of a capital lease. A company has entered into a capital lease agreement to lease production machinery from another company. Below, we’ve discussed the example that defines a capital lease agreement.
Monthly payment and annual interest will be charged on the basis of:
Present Value of manufacturing equipment = $11,000
The asset’s scrap value at the end of useful life = $0
Monthly lease payment (end of every month) = $200
Interest rate = 12%
The lease period is slightly less than the usable life of the production machinery. For example:
Lease term = 6 years
Usable life of the machinery = 7 years
When the lease term ends, the lessee takes over as the legal owner, or they have the option to transfer their ownership from one company to another.
The lessee has the option to purchase the underlying asset at a price lower than its current market value, as there’s a bargain price option with no salvage value specified.
Capital leases must meet at least one of the following criteria defined by Generally Accepted Accounting Principles (GAAP) in the United States:
If the lease meets any of the above criteria, it is classified as a capital lease.
A capital lease, or finance lease, is a long-term contractual agreement where a lessee rents a non-current fixed asset (PP&E) from a lessor for a predetermined period in exchange for periodic interest payments. It is a type of lease agreement where the lessee owns the characteristics of an owner, along with the associated risks and rewards. The lessee treats the leased asset as if they purchased and financed it through the lease agreement.
Below are some key features of a capital lease which include:
An operating lease is a contract that allows for the use of an asset but does not convey any ownership rights of the asset. It is similar to a short-term rental agreement where the lessee periodically pays the lessor to utilize an asset. The lessor maintains ownership, and the lease payments are viewed as operating costs. Assets commonly leased under such agreements involve commercial vehicles and properties (like office spaces, retail outlets, and storage facilities).
A capital lease is longer-term in which the lessee has some ownership rights related to the asset taken on rent at the end of the lease period. It is recorded as both an asset and a liability on the lessee’s balance sheet. Also, lease payments are divided into principal and interest components, similar to loan payments.
| Criteria | Capital Lease | Operating Lease |
| Ownership Transfer | Ownership can be transferred to the lessee. | Ownership typically remains with the lessor. |
| Bargain Price | Often includes a bargain purchase option. | Does not include a bargain purchase option. |
| Balance Sheet Representation | Asset is treated as owned by the lessee. | The asset is treated as rented by the lessee. |
| Risks and Rewards | The Lessee bears significant ownership risks and rewards | Minimum significant ownership risks and rewards for the lessee. |
| Lease Duration | Longer lease term, covering a major part of asset’s useful life. | Usually, shorter lease terms as compared to the asset’s useful life. |
| Accounting Treatment | Considered more like purchase of the asset using debt financing | Handled as a rental agreement under accounting standards. |
| Present Value (PV) | Preset Value of lease payments is usually close to the asset’s cost. | The present Value of lease payments is typically lower than the asset’s fair market value. |
There are several advantages and disadvantages to capital leases, which are as follows:
A capital lease is an example of accrual accounting’s inclusion of economic events, which requires a company to calculate the present Value of an obligation on its financial statements. For instance, if a company estimated the present Value of its obligation under a capital lease to be $100,000, it then records a $100,000 debit entry to the corresponding fixed asset account and a $100,000 credit entry to the capital lease liability account on its balance sheet.
Just because a capital lease is a financing arrangement, a company must break down its periodic lease payments into an interest expense based on the company’s applicable interest rate and depreciation expense. If a company makes $1,000 in monthly lease payments and its estimated interest is $200, this produces a $1,000 credit entry to the cash account, a $200 debit entry to the interest expense account, and a $800 debit entry to the capital lease liability account.
A company must also depreciate the leased asset, which is a factor in its salvage value and useful life. Let’s say an asset has a 10-year useful life and no salvage value based on the straight-line basis depreciation method; the company records an $833 monthly debit entry to the depreciation expense account and a credit entry to the accumulated depreciation account. When the leased asset is disposed of, the fixed asset is credited, and the accumulated depreciation account is debited from the remaining balances.
The accounting treatment on financial statements for capital leases is very different from how operational leases are accounted for. When you account for an operating lease, only the lease payment is recorded in the accounting records. It is an operational expense, and the payment affects the profit and loss account. In an operational lease, the company does not have any ownership of the asset. It does not get included on the balance sheet. So, there is no depreciation calculated for it.
However, a capital lease involves the transfer of the asset’s ownership to the lessee. So, the present market value of the asset is included on the balance sheet. The depreciation value is also affected by the company’s income statement. It helps to increase the company’s total assets and total liabilities, as well as provide some tax benefits to the lessee.
The following process can do the accounting treatment for the capital lease:
| Steps | Account | Debit (Dr) | Credit (Cr) |
| Initial Recognition | Right of Use Asset | Dr | |
| Lease Liability | Cr | ||
| Cash (for initial payments) | Cr | ||
| Subsequent Measurement | Depreciation Expense | Dr | |
| Accumulated Depreciation | Cr | ||
| Lease Liability (Principal Reduction) | Dr | ||
| Interest Expense | Dr | ||
| Cash (Lease Payment) | Cr | ||
| Income Statement Impact | Depreciation Expenses | Dr | |
| Interest Expense | Dr | ||
| Cash Flow Statement Impact | Interest Expense (Operating Expense) | Dr | |
| Lease Liability (Financing Activities) | Dr |
According to the U.S. GAAP (generally accepted accounting principles) reporting standards, the Present Value (PV) of the future lease payments associated with the arrangement represents the carrying value of the fixed asset (PP&E).
From a lease accounting perspective, a capital lease is treated as if the lessee has purchased the asset using debt financing. The asset and the associated lease liability are recorded on the lessee’s balance sheet. Each lease payment is allocated between the reduction of the lease liability and interest expense.
Capital leases impact the lessee’s financial statements in the following ways:
The Present Value (PV) of the lease payments is recognized as a long-term fixed asset, with the offsetting entry being a “credit” to the capital lease liability account. The Value of the leased asset is recorded in the assets section, and the capital lease of equal Value is recorded in the liabilities section. Hence, the accounting equation remains true (i.e. assets = liabilities + equity).
The lessee will report interest expense on the lease liability and depreciation expense on the leased asset. The lessee recognizes a depreciation expense throughout the leasing term, which will be embedded within the cost of goods sold (COGS) or operating expenses line item, as well as the implied interest expense. The depreciation expense reduces the carrying Value of the fixed asset on its balance sheet. By the end of the lease term, the balances of the fixed asset and offsetting lease liability account must be zero.
Lease payments are classified as a combination of both principal (reduction of lease liability) and interest payments (interest expense) as the depreciation is a non-cash expense. It is treated as an add-back on the cash flow statement.
Thus, it’s important for the business owners to differentiate between capital leases and operating leases, as the accounting treatment can significantly affect a company’s financial ratios and overall financial position.
A capital lease, or finance lease, provides several ownership benefits and risks to the lessee, generally recorded on the balance sheet. This type of lease helps businesses stay competitive and grow over time.
By leasing equipment instead of purchasing it outright, companies can conserve their cash reserves and invest in more sustainable practices. It allows you to access the latest and most advanced equipment, which will make your operations more efficient and profitable. For example, you can lease new machinery that is more energy-efficient or implement environmentally friendly processes, reducing waste and improving productivity.
