Capital Lease: Definition and Example

SHARE

capital lease
| Updated on: August 27, 2021

Not all businesses own their premises or equipment. Rentals and leases are a means for a business to operate in a property or use an asset without owning it. However, a capital lease is different from a simple operating lease. An operating lease does not affect the ownership of the asset throughout and after the lease period but a capital lease does.

What is capital lease?

A capital lease (or finance lease) is an agreement where the lessor has agreed that the ownership of the asset will be transferred to the lessee when the lease period is over. It allows the lessee the choice of buying the asset at a bargain price that is lower than the market value at the end of the lease period. A capital lease is long-term and is not cancellable. If the lease does get cancelled the lessee would have to bear any resulting loss. When the lease term ends the lessee becomes the owner of the asset and can claim finance and depreciation charges. A capital lease can be used for a property as well as an asset. For example, a manufacturing company can obtain a piece of production machinery for their operations through a capital lease. Companies use capital leases for land, buildings, ships, aircraft, engines and very heavy machinery.

How does capital lease work?

A capital lease is different from an operating lease. An operating lease is very similar to a rental agreement. It is an agreement that gives the lessee the right to use the property of the lessor for the specified time period, There is no transfer of either the ownership or the risks and they remain with the lessor. This is the key difference between an operating lease and a capital lease.

Some of the features of a capital lease are:

  • The ownership of the asset/property is transferred to the lessee when the lease period ends
  • The lease also has the option of a bargain price at the end of the period that would be less than the market value at that time
  • The usual lease period is around 75% of the useful life of the asset
  • When you calculate the present value of the lease payments they would be more than 90% of the current market value of the asset
  • It happens often that the asset is so unique that it holds little or no value to the lessor at the end of the lease period
  • A capital lease is unique because even though it is similar to a rental agreement, it is treated as an asset on the company’s financial accounting

Accounting process for capital lease

The accounting treatment on financial statements for capital leases is very different from how operational leases are accounted for. When you account for an operating lease, only the lease payment is recorded in the accounting records. It is an operational expense and the payment affects the profit and loss account. In an operational lease the company does not have any ownership of the asset. It does not get included on the balance sheet. So, there is no depreciation calculated for it.

A capital lease however involves the transfer of the ownership of the property or asset to the lessee. So, the present market value of the asset is included on the balance sheet. The depreciation value is also factored in the company’s income statement.

The lease itself is considered as a loan and so the interest payments are expensed on the income statement. The net value of all the future payments towards the lease is the loan amount that is treated as a liability. So, capital leases recognise the lease as an expense sooner than operational leases do.

Advantages and disadvantages of capital lease

Lease Type

Advantages

Disadvantages

Capital Lease

The lessee obtains ownership at the end of the lease term

Since the company can claim depreciation of the asset, it reduces the taxable income

The accounting of the interest expense also reduces the taxable income of the company

The  lessee is tied to the asset or property for the long term

There is a high risk of the asset becoming outdated or obsolete as time progresses

More complex to account

Operating Lease

An operating lease gives the lessee the flexibility of changing, upgrading, updating or replacing the asset to the latest in the shorter term

Accounting for the lease payments of an operating lease is much simpler

The lease payments of an operating lease are usually tax-deductible in the accrual basis of accounting

There is no ownership of the asset.

Example of capital lease

We can use a manufacturing company as an example of a capital lease. The company XYZ has entered into a capital lease agreement to lease production machinery from company ABC.

We see that this example fulfils the definition of a capital lease agreement.

Features Of The Lease

How Does The Lease Satisfy The Conditions Of A Capital Lease?

Current Value of the machinery = $100,000

Monthly Payment =  $18,000

Annual Interest 12%

Monthly payment and annual interest charged

Lease term = 5 years

Usable life of the machinery = 6 years

It is for a period of time that is slightly less than the usable life of the production machinery

The lessee will buy the production machinery at the end of the lease period for a lesser value than the market value.  Salvage value specified = No

There is a bargain price at the end of the lease and no salvage value specified

The machinery ownership will transfer from ABC to the company XYZ at the end of the lease period.

There is a transfer of ownership

Accounting treatment of capital leas

Value

Debit This Account

Credit This Account

Present value of the machinery

Fixed Asset

Lease Liability

Interest portion of monthly payment

Interest Expense

Cash or Bank Account (as applicable)

Capital portion of monthly payment

 

Lease Liability

Cash or Bank Account (as applicable)

Asset disposal amount

Accumulated Depreciation

Net Asset Account

  • A capital lease is accounted for as the purchase of an asset, so the depreciation for the asset is also recorded in every accounting period

  • When the asset is disposed of, if the sale price is different from the carrying cost of the asset, the difference amount is accounted for as capital gain or loss on the balance sheet and other financial statements

Account your capital lease simply and easily

Making the right accounting records for your property lease is easy when you use Tally. You merely record the relevant transactions, and the amounts reflect on the appropriate financial accounting reports automatically. It also accounts for the disposal of the asset at some point after the asset is transferred to the lessee. Not juts accounting capital lease, TallyPrime helps you manage managing your business in an efficient manner. The wide rang of insightful business reports helps you stay top of your financials. The best part is that you can personalise the reports the way you it suits you.

TallyPrime

Accounting solutions to help you manage your business just the way you want.