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 assets, 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 lease.
- Depreciation Claim: the lessee of the asset can show the same asset in its balance sheet and claim depreciation on this. This setup reduces the taxable income of the lessee 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 statement, 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 lessor in its balance sheet. These lease payments are paid off periodically. This increased debt directly impacts the debt to equity ratio 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.
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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 –