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Capital Leases



Definition

Capital leases, also known as finance leases, are long-term lease agreements where the lessee acquires the rights to use an asset and bears the risks and benefits of its ownership. These leases are essentially considered as an acquisition of the asset financed by a loan. The lessee records the leased asset as an owned asset on its balance sheet, along with the corresponding lease liability.

Phonetic

The phonetics of the keyword “Capital Leases” is: /ˈkæpɪtəl ˈlizs/

Key Takeaways

  1. A capital lease, also known as a finance lease, is a long-term agreement where the lessee acquires the right to use the leased asset, and it is recorded as an asset on the lessee’s balance sheet. This type of lease is generally used for acquiring high-value equipment, machinery, or property.
  2. During the lease term, the lessee is responsible for paying the lease payments, which usually include both principal and interest components. These payments are recorded as both a reduction in the lease liability and as interest expense on the lessee’s income statement. The leased asset is also subject to depreciation, which impacts the lessee’s financial statement.
  3. At the end of the lease term, the lessee may have the option to purchase the leased asset at a predetermined residual value, renew the lease, or return the asset to the lessor. The terms and conditions of a capital lease usually transfer the risks and rewards of the ownership to the lessee, making it different from an operating lease in which the lessor retains these risks and rewards.

Importance

Capital leases are important in the business/finance world because they allow companies to acquire assets and financing without a large upfront investment. Through this long-term arrangement, the lessee (the company leasing the asset) benefits from the rights and usage of the leased assets while agreeing to make regular payment installments over the lease term. Capital leases impact the financial statements of a company, leading to increased assets and liabilities on the balance sheet. At the same time, the depreciation of the leased asset and the interest expense from lease payments affect the income statement, thereby providing tax benefits. By understanding the nature and implications of capital leases, businesses can make informed decisions on how to strategically acquire crucial assets and manage their financial obligations, ultimately contributing to their growth and expansion objectives.

Explanation

Capital leases, also referred to as finance leases or finance agreements, serve as a vital tool for businesses seeking to acquire long-term assets without a large upfront capital investment. The purpose of a capital lease is to allow organizations to utilize critical equipment, machinery, or other property for an extended period while making periodic payments to the leasing entity. For businesses, these long-term assets are crucial to expand operations, increase production capacity, or launch new product lines. By choosing a capital lease arrangement instead of a large initial purchase, companies can better manage their cash flow, maintain financial flexibility, and conserve capital for other critical business purposes. Furthermore, capital leases offer various financial advantages to organizations. Firstly, this leasing option enables a business to retain the economic benefits and risks associated with asset ownership without legally owning the asset. As a result, the asset is recorded on the company’s balance sheet, contributing to its overall net worth, while the liability for the lease payments is considered a long-term debt obligation. Additionally, businesses may also benefit from tax deductions associated with depreciation expenses and interest payments on the lease. By entering into a capital lease, companies can balance the need to acquire essential long-term assets without straining their financial resources, thus promoting growth and stability within the organization.

Examples

1. Commercial Real Estate Leasing: A retail store owner enters into a capital lease agreement for a prime storefront location in a shopping mall. The lease term is for ten years, and the present value of lease payments is equal to 90% of the property’s fair market value. In this scenario, the store owner essentially finances the store through a capital lease, and at the end of the lease term, the business will have the option to purchase the space at a significantly reduced price. 2. Industrial Equipment Financing: A manufacturing company requires a specialized piece of equipment for its production process but doesn’t have enough funds to make an upfront purchase. The company decides to enter into a capital lease agreement with an equipment leasing company, where the lease term covers a significant portion of the equipment’s economic life. The terms of the agreement include a nominal purchase option at the end of the lease term, allowing the manufacturing company to retain the equipment upon final payment. In this case, the company benefits from a fixed monthly expense while eventually owning the asset at the end of the lease. 3. Fleet Vehicle Acquisition: A transportation and logistics company requires a fleet of trucks for its operations. Instead of buying the trucks outright, the company enters into a capital lease agreement with a vehicle leasing provider for multiple vehicles. The lease term accounts for a significant portion of the trucks’ useful lives, and at the end of the lease term, the company has the option to purchase the vehicles at a small residual value. Through capital leasing, the company is able to spread the expense of acquiring the vehicles over several years while maintaining the benefits of asset ownership.

Frequently Asked Questions(FAQ)

What is a Capital Lease?
A capital lease, also known as a finance lease, is a long-term lease agreement where the lessee assumes substantially all the risks and rewards of ownership of the leased asset. It is essentially a financing arrangement that allows the lessee to acquire assets without purchasing them outright.
How does a Capital Lease differ from an Operating Lease?
In a capital lease, the lessee effectively gains ownership of the asset, while an operating lease is a short-term rental agreement where the lessor retains ownership of the asset. Capital leases are typically used for assets that will be used long-term, whereas operating leases are more suited for temporary use of assets.
What are the criteria for a lease to be considered a Capital Lease?
According to accounting standards, a lease should be classified as a capital lease if it meets any one of the following criteria:1. The lease transfers ownership of the asset to the lessee at the end of the lease term.2. The lease contains a bargain purchase option, allowing the lessee to buy the asset at a discounted price at the end of the lease term.3. The lease term is equal to or greater than 75% of the asset’s economic life.4. The present value of the lease payments is equal to or greater than 90% of the fair market value of the asset.
How is a Capital Lease recorded on financial statements?
In a capital lease, the lessee records the leased asset as a fixed asset and the lease obligations as a liability on the balance sheet. The leased asset is depreciated over its useful life, and the lease payments are divided into principal and interest components. The interest expense is recorded on the income statement, while the principal portion reduces the lease liability.
What are the tax implications of a Capital Lease?
For tax purposes, a capital lease typically allows the lessee to claim depreciation expense and interest expense deductions. These deductions can help reduce the lessee’s taxable income. However, tax regulations may vary depending on the location and specific details of the lease agreement.
What are the advantages of a Capital Lease for a business?
Some advantages of a capital lease include:1. Acquisition of assets without large upfront costs: Capital leases allow businesses to acquire expensive assets without paying the full purchase price immediately.2. Tax benefits: Lessees can claim depreciation and interest expense deductions on capital leases.3. Potential ownership: Depending on the lease terms, the lessee may have the option to purchase the asset at the end of the lease term.
What are the disadvantages of a Capital Lease for a business?
Some disadvantages of a capital lease include:1. Increased liabilities: Capital leases are recorded as liabilities on the balance sheet, potentially affecting financial ratios and credit ratings.2. Commitment to a long-term lease: Capital leases usually have longer terms and may be difficult to terminate early, potentially limiting a business’s flexibility in managing its assets.3. Obsolescence risk: The lessee may be responsible for an asset that becomes obsolete or outdated over the lease term.

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