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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.
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.
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 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.
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 |
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. |
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 |
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 |
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.
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