What is a Capital Lease?
A capital lease sometimes referred to as a finance lease, can be used buy a business to fund the use of an asset.
Under the capital lease definition, a third party (the lessor) will purchase the chosen asset, retain ownership, and rent the asset for the term of the capital lease to the business (the lessee).
The rental payments are such that the lessor recovers the cost of the asset and also makes a profit from the interest and fees included in the rentals.
A capital lease is identified by a number of characteristics:
- Ownership of the asset is transferred to the business at the end of the lease term.
- The capital lease contains a purchase option for the business to buy the equipment at a price lower than the market value.
- The capital lease term is for the majority of the useful life of the asset (US Accounting standards stipulate this as a term greater than or equal to 75% of the assets useful life).
- The present value of the lease rental payments equals substantially all of the value of the asset (US Accounting Standards stipulate the rental payments exceed 90% of the total original cost of the asset).
These characteristics of a capital lease are such that the business effectively has control of and owns the asset, and will capitalize the cost of the asset in its balance sheet, and treat it like any other long term asset.
A capital lease is in contrast to an operating lease where the business pays a rental to use the asset for a period of time. The total rental payments are a minor portion of the cost of the asset and ownership does not transfer at the end of an operating lease. In these circumstances the business does not capitalize the asset but treats the rental payments as an operating expense in the income statement.
For further information see the Wikipedia capital lease definition.
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About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.