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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.
- 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 leasing of the asset. The basic difference between these two options is the ownership is transferred at the beginning of the lending or borrowing period, while in 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 Aircrafts, 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.
Criteria of Capital Lease
Given below is the criteria for the capital lease.
- A legal agreement or contract between the owner of the assets, who is the lessor, and the user or the lessee
- It is an agreement like the purchase of the asset at a rate lesser than the prevalent market value
- Periodic lease payment of rentals by the lessee, who is the user of the asset, during the entire fixed term of the asset
- The life of the lease or the lease term to be considered is approximately 75% (or higher) than the asset’s actual useful life
- The lessee gains ownership of the asset at the end of the agreed lease period.
- If compared to any loan, there will be no processing fee for the capital lease. Also, the time involved in the entire processing between the lesser and lessee is comparatively quite less when compared to a typical loan scenario.
- The present value of the rentals from the capital lease setup is usually greater than 90%of the fair value of the asset at the time of the lease agreement
Accounting Treatment of Capital Lease
Below is the impact of Capital Leases on the Lessee Account.
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Effect on Balance Sheet
Accounting treatment for capital lease is an example of accrual accounting, which is an accounting method used to measure a company’s or business performance by recognizing the occurrence and the period of an economic event, irrespective of when the cash transactions occur.
For example, If a company has taken an asset on capital lease for $50,000 – it makes two entries for the same in the books of accounts – it records $50,000 under the same fixed asset account and $50,000 credit entry to the capital lease liability account in the balance sheet.
Effect on Income Statement
- The periodic payments to pay the lease needs to be broken down as per the interest payments at an applicable interest rate.
- For example, A company has leased an asset and is making $2000 per month. Also, its estimated interest per month is $500. These transactions need to have respective entries – $2000 credit entry to the cash account and a $500 debit entry to an interest expense account. This would in turn result to an $800 amount to be a debit entry to the capital lease liability account in the balance sheet as well.
- Interest expense = Discount rate times the Lease liability at the beginning of the period
- Since the leased asset is a fixed asset, it is liable to depreciation. It, therefore, also, needs to calculate the useful life of the asset and ultimately its salvage value.
- For example, the useful life of the asset leased which is valued at $50,000, let’s say heavy machinery, is 10 years. The depreciation method to be used is the straight line method ( simple SLM method) – according to which there is no salvage value. Hence, if the company maintains a monthly book of records, it needs to debit the depreciation expense account by $417 per month and an equivalent credit entry in the accumulated depreciation account with the same $417 per month.
- In case the pre-determined lease period is completed, and when the leased asset is to be disposed of, the fixed account is credited and the accumulated depreciation account is debited of the balance after accounting the $417 per month till completion.
- If lease transfers ownership, depreciate the asset over the economic life of the asset.
- If the lease does not transfer ownership, depreciate over the term of the lease.
Effect on Cash Flows
- Only the portion of lease payment that is considered interest payment reduces Cash flow from Operations (CFO)
- Part of the lease payment considered payment on principal reduces Cash flow from Financing (CFF).
Advantages of a Capital 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 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 same 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
Disadvantages of a Capital Lease
- Debt to Equity Ratio: In 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 serious manner, due to which maintain the interest of all the stakeholders becomes really difficult.
- Maintenance Charges: once both the parties involved enter into the agreement, the lessee is expected to maintain and make any repairs, as required. This 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 has been a guide to Capital Lease and its definition. Here we discuss the criteria to classify a lease as capital lease along with its accounting treatment. You can learn more about accounting from the following articles –