Introduction to capital lease
To qualify as capital lease, one of the following criteria should be met:
- Ownership criteria: At the end of lease tenure, the ownership rights shift from the lessor to the lessee.
- The option of Bargain buys: Under a capital lease, the lessee can buy the asset from the lessor at the end of the lease term for a bargain price. This however is generally negotiated at the beginning of the lease period.
- Lease term: To qualify as a capital lease, the tenure of the lease shall be at least 75 % of the useful life of the asset. The nature of the lease during the time is non-cancelable.
- Present value criteria: The present value of the minimum lease payments required under the lease is at least 90% of the fair value of the asset at the inception of the lease.
A capital lease is a kind of rental agreement between the two parties i.e. lessee and lessor. But, GAAP treats such agreement as a capital lease if the agreement meets one of the conditions as laid above. This type of lease impacts the financial statements of the lessee. This impact covers interest expense, depreciation, assets, and liabilities.
On the other hand, the capital lease shall include the transfer of ownership rights of an asset to the lessee. Hence, a capital lease is mirrored as a loan as under this lease, interest expense is shown on the income statement.
There are two parties to lease, hence, advantages and disadvantages to both of them would vary as given below:
For the Lessee
Advantages of capital lease
- Ownership benefit: Capital lease includes the benefit that lessee may get the purchased asset if has used the asset for more than 75% of its life. Further, at the end of the lease term, the lessee gets the option to buy the leased asset at a bargain price. In short, ownership benefits accrue to the lessee.
- Claim to depreciation: The lessee can treat the leased asset on its balance sheet by claiming depreciation for the asset. The depreciation is an expense for the company. Hence, when it is expensed on the income statement, it reduces the profit of the lessee’s company.
- Claim to interest expense: The lessee pays the interest to the lessor. Hence, he can treat this interest as an expense in his income statement. This would reduce the profit and tax liability of the lessee.
- Cheaper: The lessor funds the assets in a capital lease. Furthermore, the rate of interest for the capital lease-funding is comparatively cheaper than a bank loan.
Disadvantages of capital lease
- Negative debt to equity ratio: After getting into a capital lease, the lessee adds debt in his balance sheet that has to be paid in form of lease payments. This increases the debt to equity ratio of the lessee’s balance sheet. This would make it difficult for the lessee to raise capital in the future.
- Risk of being obsolete: The lessee can get the ownership rights. What if at the near end term of the eligibility of ownership, the leased asset becomes outdated. This often becomes the case as we are living in a rapidly changing technological age. So, there are high chances that the lessee will be stuck with obsolete assets during the time of lease.
- Maintenance Responsibilities: The lessee has to bear all the repair and maintenance of the asset during the period of the lease. There are various costs of maintenance like regular maintenance costs, insurance costs, downtime costs, repairs, etc. If by any bad luck, the maintenance cost can multiply in case there is an accident or any other cause.
For the Lessor
Advantages of Capital lease
- A healthy return on investment The lessor usually has free cash lying around and they want to make a return on this free cash available. A capital lease is one of the easiest forms of investment as the returns are usually on the healthier side. The risk involved on the other hand is usually low as the assets can be always seized in case of default. Hence, a capital lease is a kind of investment where risk is measured although resulting in higher returns.
- Good asset price: Many companies engage in this business of leasing. Multiple leasing agreements are made among companies. These companies have special arrangements in place with manufacturers to take back the asset in case of return. A suitable asset price is offered when these assets are returned.
Disadvantages of capital lease
- Risk of holding an obsolete asset: There is always a risk with the lessor that at the end of the lease term, the lessee decides to return the asset. In that scenario, the lessor is stuck with an old asset. In case of acceleration of asset naturally due to overuse, the lessee may return the asset and decide to refuse the bargain offer. This will naturally increase the risk to the lessor of holding an obsolete asset.