What is a Capital Lease?
Capital Lease is a legal lease agreement of any business equipment or property which is equivalent or similar to a sale of an asset by one party called the lesser to the buyer who is called the lessee, and the lesser agrees to transfer the ownership rights to the lessee once the lease period is completed and are generally non-cancellable as well as long term in nature.
- It is a long term and non-reversible / non-cancellable type of lease. In situations where a company or a business has lesser funds to purchase an asset, it chooses to either borrow or lease the asset. The fundamental difference between these two options is the ownership is transferred at the beginning of the lending or borrowing period. In contrast, in the case of leasing, the ownership is passed only on completion of the lease period. Therefore, this type of lease can be considered as debt and incur interest expense for the lessee.
Examples of the assetsExamples Of The AssetsExamples of assets include all current, capital and intangible assets owned by a company and used for accounting purpose. Some of these are cash, accounts receivable, building, plant and equipment, goodwill and patents., including Aircraft, lands, buildings, heavy to very heavy machinery, ships, diesel engines, etc., are available for purchase under capital lease. Smaller assets are also available to be financed and are considered under another type of lease called the operating leaseOperating LeaseAn operating lease is a type of lease that allows one party (the lessee), to use an asset held by another party (the lessor) in exchange for rental payments that are less than the asset's economic rights for a particular period and without transferring any ownership rights at the end of the lease term..
- Depreciation Claim: the lessee of the asset can show the same asset in its balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. and claim depreciation on this. This setup reduces the taxable income of the lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. company
- Ownership: the lessee can use the asset for more than 75% of its life. The lessee also has an option to purchase the asset after the termination of the lease period and at a rate lower than the current market rate of the asset.
- Interest Expense: the lesser needs to pay the interest that is charged by the owner of the asset. Since it is an expense for the company, it shows the interest expense as an expense in the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements., which therefore reduces the taxable income of the business.
- Off-Balance sheet debt: Capital leases are counted as debt
- No risk of obsolescence: any company can act as a lesser and reduce its risks and lower productivity due to the risk of obsolescence of any type of fixed assets
- Debt to Equity Ratio: In the case of a capital lease, there is a creation of debt by the lessorLessorA lessor is an individual who legally owns the asset granted on a lease (rented for a long tenure) to the lessee who pays a single lump sum amount or regular payments for using that asset. in its balance sheet. These lease paymentsLease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration. are paid off periodically. This increased debt directly impacts the debt to equity ratioImpacts The Debt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. in a severe manner, due to which maintain the interest of all the stakeholders becomes difficult.
- Maintenance Charges: once both the parties involved enter into the agreement, the lessee is expected to maintain and make any repairs, as required. It adds to the existing costs for the company.
- Risk of holding Obsolete Assets: At times, the lessor makes a good move in leasing out an obsolete part or the entire asset
There are two different types of leasing process- Capital lease and Operating Lease. Depending on the requirements of the business and its tax situation, a company may pick any one of the lease types or even a combination of both the lease types.
This article has been a guide to Capital Lease and its definition. Here we discuss the capital lease examples along with its advantages and disadvantages. You can learn more about accounting from the following articles –