Capital Lease

What is a capital lease?

A capital lease, also known as a finance lease, is a legal agreement to pay for the temporary use of business equipment. In accounting, a capital lease is recorded as an asset and as a liability. 

Capital leases give companies long-term use of expensive equipment for which it doesn’t have the funds to pay upfront. Most agreements transfer ownership to the business at the end of the lease term outright or with the payment of an additional sum. 

The lessee is responsible for the upkeep of the equipment, such as maintenance and repairs. A capital lease differs from a short-term agreement called an operating lease, in which ownership isn’t transferred to the lessee. 

Companies often lease numerous pieces of equipment with capital and operating lease agreements. Asset leasing software helps companies manage the entire lease lifecycle – from loan origination to making payments to navigating the end of a contract. With this software, a company can ensure its compliance with accounting principles and reporting standards.

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Basic elements of a capital lease

Business owners may question whether a lease agreement they signed is a capital lease. The accounting standards codification (ASC) states that a contract is a capital lease if it meets at least one of the following criteria:

• Equipment ownership transfers at the end of the lease period.
• The lessee has an option to buy the equipment for a reduced price at the end of the lease. This opportunity is often called the bargain purchase option.
• The lease term spans at least 75% of the years that the item will reasonably function, also known as the asset's useful life. 
• The present value of the lease payments is at least 90% of the fair market value. 
• The leased item is unique or specialized equipment with no value for the lessor when the term ends.

The Financial Accounting Standards Board added the fifth criterion after the others with the release of ASC 842. 

Benefits of a capital lease

Companies that want to pay for an asset over time may opt for a capital lease. This type of lease works well for equipment with a useful life of several years, such as heavy machinery and tools. Some of the benefits of a capital lease include:

• Claiming depreciation. For accounting purposes, the lessee owns the equipment subject to a capital lease, so it’s treated as an asset. The lessee records the depreciation of this asset, which lowers its taxable income.
• Reporting interest. The lessee must pay interest to the lessor. The lessee records this interest as an expense on the balance sheet and deducts it from its profit.
• Achieving ownership. Unlike renting, a capital lease allows companies to achieve ownership at the end of the agreed-upon term. 

Capital lease vs. operating lease

Companies must consider many options when acquiring expensive equipment, including obtaining a bank loan, renting, or leasing. Companies have two main options for leases:

A capital lease is designed for businesses that want to own pricey equipment, allowing them to make monthly payments instead of paying upfront. A capital lease works best for equipment like forklifts or die-casting machines because the lessee owns and uses them after the lease period. The lessee treats the equipment as both an asset (due to ownership) and a liability (due to interest) on their balance sheet.

An operating lease works more like a rental agreement because ownership does not get transferred to the lessee. Since the lessor retains ownership, they are typically responsible for maintenance. As with a capital lease, the company makes monthly payments. However, an operating lease is usually a short-term agreement, so it works better for technological equipment. Operating lease payments are considered operating expenses, so they are tax deductible.