Capital Lease: What is Capital Lease and How Does It Work?

What is Capital Lease?

A capital lease can be defined as a contract that entitles a renter to use an asset in exchange for periodic lease payments.

However, the lease is known to have economic characteristics of asset ownership for accounting-related purposes.

The capital lease mainly requires the renter to book assets and liabilities that are associated with the lease in the case where the rental contract is able to meet certain criteria.

The main rationale behind capital lease tends to be the fact that it transfers the risks and the rewards associated with the ownership of the asset to the respected lessee.

When any company procures an asset, it is normal protocol for them to bear all the risks that are associated, including maintenance cost, as well as repairs that are inculcated in this aspect.

Capital Lease transfers all these risks to the lessee in this aspect.  

Difference between Capital Lease and Operating Lease

A capital lease is often confused with an operating lease. Regardless of the fact that both of these lease types involve using assets that are not owned (or purchased) upfront by the parties involved, there are some technical differences between both of them.

An operating lease is structured differently and therefore, has a different accounting treatment as compared to a typical capital lease.

The main premise of an operating lease stands to be the fact that it allows for the use of the asset, but does not convey any ownership rights of the asset.

It might be for a shorter time duration too. However, capital lease mostly spreads across a number of years.

How does Capital Lease work?

The criteria for a capital lease is contingent on a multitude of factors. These requirements and criteria are as follows:

  • Ownership: A lease can be classified as a capital lease in the case where the ownership is transferred from the lessor to the lessee at the end of the contracted lease period. Although this might not be a mandatory clause in the lease agreement, it is still considered to be quite an important aspect.
  • Lease Term: Capital Lease contracts mainly spread over a longer time duration. In most cases, capital lease contracts span a period of at least one year. The period of the lease should cover at least 75% of the useful life of the asset. Furthermore, the lease is non-cancellable during the lease period.
  • Present Value: The present value of the minimum lease payments required under the lease is at least 90% of the fair value of the asset that exists at the beginning of the lease contract.  
  • Bargain Purchase Option: The bargain purchase option implies that the lessee can buy the asset from the lessor at the end of the lease term for a price that is below the market price.
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In the case where the criteria mentioned above is met, the lessee is supposed to record the lease as a capital lease.

Accounting for Capital Lease

A Capital Lease can be described as an example of accrual accounting. This is because it includes all the economic events, which are required for a company to calculate the present value of an obligation on its financial statements.

Since the capital lease is considered to be a financing arrangement, it is important for the organization to ensure that they are able to break down the periodic lease payments into an interest-based expense that is related to the applicable interest rate, as well as the depreciation expense that the company has incurred.

In the case where the aforementioned criteria regarding capital lease is properly fulfilled, it is important for the company to account for the Capital Lease in the following ways:

  • Initial Record Keeping: This mainly requires calculating the present value of all the lease payments. This is mainly recorded as the cost of the asset. The recorded amount is debited to the asset account, whereas the credit entry for this transaction stands to be the changes in the capital lease liability account.

For example, if the present value of the lease payments amounts to $50,000 then $50,000 is going to be debited to the relevant asset account, whereas the corresponding credit entry of $50,000 is going to be made in the liability account. The main objective here is to capitalize on the leased asset. This is summarized in the following journal entry:

Dr. Asset $50,000

 Cr. Asset Lease Liability $50,000

  • Lease Payments: The rationale behind lease payments refers to the lessee recording the relevant interest expenses, as the invoice is received from the lessor. The main aim behind this particular accounting entry is to record a portion of the leased asset invoice as interest, whereas the remainder of the lease payment and the interest expense is the amount by which the liability account decreases. The main objective behind each entry in lieu of lease payments is to bring down the liability account to zero.
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For example, if the lease invoice states an amount of $2000, out of which $500 is interest expense, then the transaction would be to debit Interest Expense as $500, and the remainder of the amount (difference between the invoiced amount and the interest expense) i.e. $1500 will be debited in the Liability Account. The corresponding credit entry for this particular transaction would be to credit Bank, or Accounts Payable.

Dr. Asset Lease Liability $1500

Dr. Interest Expense $500

Cr. Bank $2000

  • Depreciation: Given the fact that the asset that has been acquired via Capital Lease is supposed to be treated as an asset in the books, it is important for the lessee to record depreciation in a manner similar to the situation where they had purchased the asset in the first place. In other words, depreciation is supposed to be recorded just like it is recorded normally.

Advantages of Capital Lease

Capital Leases are highly common in the modern-day business dynamic, primarily because of the fact that they are considered to be increasingly resourceful on grounds of enabling companies to expand, without having to bear upfront capital expenses. In addition to that, there are a handful of advantages of capital leases, from the perspective of both, the lessor, and the lessee. These advantages are enlisted below:

  • From the perspective of the lessee: From the perspective of the lessee, it can be seen that capital lease results in ownership benefits. Other than that, it also helps companies on the front of depreciation expense claims, as well as interest expense claims. Therefore, regardless of the apparent high cost involved with capital leases, they are considered to be helpful because it helps the company to get the asset, without having to arrange for expensive sources of finance to procure the asset from elsewhere.
  • From the perspective of the lessor: As far as the lessor is concerned, he benefits from the capital lease because it helps the lessor to achieve a better risk-return balance, as well as a better asset price that goes with it.  
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Disadvantages of Capital lease

Regardless of the fact that Capital lease tends to be really helpful from the perspective of companies, yet it can be seen that there are a couple of drawbacks of a capital lease that need to be accounted for. They are as follows:

  • From the perspective of the lessee: Capital Lease often results in a negative debt-to-equity ratio. Since the expense is of a considerably larger magnitude, it can be seen that it results in a negative debt-to-equity ratio. There is also an inherent risk of the asset being obsolete, because of which the realizable value of the leased asset is likely to go down than the purchase price. The responsibility of maintaining the asset is also on the lessor, and therefore, maintenance cost on the leased asset might put an additional strain on the finances of the lessee.
  • From the perspective of the lessor: From the perspective of the lessor, it can be seen that they include the risk of holding the obsolete asset. If at the end of the lease period, the bargain purchase option is not availed, then the lessor might be stuck with an asset that is outdated, or that has a low demand. Therefore, it is important for the lessor to inculcate this risk to ensure that at the end of the lease term, the risk factor is considerably low.