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What Is a Capital Lease? Definition & Characteristics

What Is a Capital Lease? Definition & Characteristics

Are you constantly upgrading your equipment or struggling to stay ahead of the competition with outdated technology? Do you need to equip an entirely new site or facility? 

Leasing new equipment can be a cost-effective way to stay competitive and boost your business's efficiency. But with so many lease options available, it can be tough to know which one is right for you. 

Enter the capital lease, a powerful tool that can help you access the equipment you need to take your business to the next level. In this blog post, we'll explore the in’s and out’s of capital leases, their benefits, and why they might be just what your business needs to thrive.

Need new or refurbished lab equipment? Excedr leases.

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What Is a Capital Lease?

A capital lease is a type of lease agreement where the lessee (the company leasing the asset) is responsible for the maintenance, insurance, and other expenses associated with the leased asset during the entire duration of the lease term. 

The lessee also has the option to purchase the asset at the end of the lease term for a predetermined price. Under a capital lease agreement, the lessee records the leased asset on their balance sheet and the lease payments as an interest expense and a liability reduction.

Leasing can help a business conserve cash, manage its finances more effectively, and acquire the assets it needs to operate and grow.

A finance lease is effectively the same as a capital lease, but the term “finance lease” is now more commonly used to describe this type of lease.

The shift in terminology is due to changes in accounting standards, specifically the adoption of the International Financial Reporting Standards (IFRS 16) and Accounting Standards Codification (ASC 842), which introduced and uses the term “finance lease” to describe what was previously known as a capital lease under Generally Accepted Accounting Principles (GAAP).

Regarding their economic substance or legal structure, capital and finance leases are the same. The primary difference is the terminology used to describe the lease under previous accounting standards.

A capital lease can be important for a business because it allows the company to acquire the use of an asset (such as equipment, machinery, or vehicles) without having to purchase it outright. This can be beneficial for a business that needs to use the asset but doesn't have the cash to buy it upfront.

With a capital lease, the business makes regular payments over a set period of time, and at the end of the lease term, they may have the option to purchase the asset for a nominal amount or return it to the lessor.

In addition, a capital lease can have tax benefits for a business, as the lease payments may be deductible as a business expense. It can also provide the business with a fixed cost structure, as the lease payments are typically fixed for the duration of the lease term. This is also true for other types of leases, specifically operating leases (or true leases), the other primary type of lease available to businesses.

When Does a Lease Qualify as a Capital Lease?

A lease can be classified as a capital lease if it meets specific criteria set by the Financial Accounting Standards Board (FASB), which is the organization responsible for creating and maintaining accounting standards in the United States.

The FASB is an independent, private-sector, not-for-profit organization that is recognized by the Securities and Exchange Commission (SEC) as the designated accounting standards setter for public companies. The FASB regularly reviews and updates the criteria for accounting for leases to ensure that the accounting standards accurately reflect economic reality and provide useful information to investors and other stakeholders.

The first criterion is if the title to the asset being leased is transferred to the lessee, either during or after the lease. The second criterion is if the lessee can purchase the asset at a bargain price at the end of the lease.

The third criterion is if the lease term is for at least 75 percent of the asset's useful life. Lastly, a lease can be classified as a capital lease if the present value of the lease payments is more than 90 percent of the asset's fair value. If one of the four criteria are met, the lease can be classified as a capital lease for financial reporting and accounting purposes.

Characteristics of a Capital Lease

There are several key characteristics to capital leases, including:

  • Transfer of ownership to the lessee at the end of the lease term
  • Long-term nature (usually for the majority of the asset's useful life)
  • Lessee is responsible for maintenance, insurance, and other expenses
  • Lessee records the leased asset as an asset on its balance sheet
  • Lease payments recorded as both an interest expense and a reduction of the company’s tax liability

We’ll go over some of these in more detail below.

Transfer of Ownership

When a business enters into a capital lease agreement, they borrow an asset for a fixed period of time from the lessor, intending to use the asset to generate revenue or provide a service to its clients.

Unlike an operating lease, which is more like a rental agreement and typically does not involve the transfer of ownership at any point (unless the company opts to purchase the asset at the end of the lease term), a capital lease is structured in a way that the lessee takes on the risks and rewards of ownership, and is therefore required to account for the asset on their balance sheet as if they own it.

At the end of the capital lease term, the lessee generally can purchase the asset for a nominal amount (known as a “bargain purchase option”), or return the asset to the lessor. If the lessee exercises the purchase option and becomes the asset's owner, the transfer of ownership is complete, and the item is no longer considered a liability on their balance sheet.

The transfer of ownership aspect of a capital lease is crucial because it allows the lessee to benefit from using the asset during the lease term and acquire the asset at the end of the lease term for a fraction of the cost of purchasing it outright. However, the value of the equipment may be pretty low after the duration of the lease term is over. So the cost-savings of buying at a reduced price may be negligible.

It also means that the lessee must be responsible for the maintenance and repair of the asset during the lease term and bear the risk of any decline in value or obsolescence of the asset over time.

Long-Term Nature of the Agreement

The nature of a capital lease agreement is long-term, typically lasting for a significant portion of the asset's useful life, which can present advantages and disadvantages for the lessee.

On the one hand, it can allow the lessee to acquire and use an asset without making a significant upfront investment or taking out a loan. However, this is true of many other lease types. Additionally, because the lease payments are treated as debt, they may be tax-deductible for the lessee.

(Operating leases offer similar tax benefits since the payments are considered a necessary and ordinary business expense. The tax code allows businesses to deduct ordinary and necessary business expenses from their taxable income, and operating lease payments typically fall under this category.)

On the other hand, because the lessee is responsible for making regular payments over a long period, a capital lease agreement can be a significant financial obligation. As mentioned, because the lessee is typically responsible for maintaining and repairing the leased asset, they may incur additional costs over the lease's life that can add up.

Maintenance, Insurance, & Other Expenses

As mentioned, companies that use capital leases are typically responsible for maintaining and repairing the leased asset throughout the lease term. As such, maintenance expenses can really add up. In addition to maintenance expenses, lessees may also be responsible for insurance, taxes, and other costs associated with the leased asset.

The impact of these expenses will depend on various factors, including the lease agreement terms, the leased asset's cost, and the company’s financial situation. Maintenance expenses, in particular, can become a significant cost for lessees, especially if the leased asset requires frequent repairs or maintenance.

Insurance costs can also become burdensome. The lessor may require the lessee to carry insurance on the leased asset, which can add to the company’s overall insurance costs.

The lessee may also be responsible for other expenses, such as taxes or licensing fees. These expenses can vary depending on the type of asset being leased and the location of the lessee’s operations, but they can quickly add up too.

It is important that businesses carefully evaluate the total cost of a capital lease, including these additional expenses when deciding whether to enter into a lease agreement.

Recorded On the Balance Sheet

How a capital lease is recorded is a key characteristic of this type of lease agreement, and involves recording the lease on your balance sheet as an asset and liability, where the leased item is recorded under assets, and the lease payments are recorded under liabilities.

As mentioned, the nature of a capital lease means the lessee is seen as having acquired the leased asset, so the asset is recorded on the balance sheet as if it had been purchased. 

At the same time, the lessee takes on liability to make lease payments over the lease term, so the lease payments’ present value is recorded as a liability on the balance sheet. More specifically, the lessee records the leased asset at its fair market value or, if lower, the present value of the lease payments.

The liability is recorded at the same amount as the leased asset. Over the life of the lease, the lessee amortizes the leased asset and the liability in a way that results in a constant periodic interest rate.

To illustrate this, suppose a lessee enters a five-year capital lease agreement for a machine with a fair market value of $100,000. The lease agreement requires the lessee to make annual lease payments of $25,000, payable at the beginning of each year. Assuming a discount rate of 10%, the present value of the lease payments is $101,491.

On the lessee’s balance sheet, the leased machine would be recorded as an asset of $101,491, and the lease obligation would be recorded as a liability of $101,491. Over the life of the lease, the lessee would amortize the leased asset and the lease obligation in a way that results in a constant periodic interest rate.

It is worth noting that the specific accounting treatment of a capital lease can vary depending on the particular terms of the lease agreement and the applicable accounting standards. You should consult your accountant to ensure the capital lease is properly accounted for per applicable standards.

Payments Recorded as Interest Expense & a Tax Reduction

Under a capital lease agreement, the lease payments are typically split into two components: a portion that represents the repayment of the principal amount borrowed to finance the leased asset and a portion that represents the interest expense associated with the borrowing.

The portion of the lease payment that represents the repayment of the principal amount is recorded as a reduction in the lease obligation (liability) on the lessee’s balance sheet, reducing the amount of the lease obligation over time and eventually resulting in the lessee owning the leased asset at the end of the lease term—if they opt to purchase the item.

The portion of the lease payment that represents the interest expense is recorded as an interest expense on the lessee’s income statement and is considered tax-deductible, reducing the lessee’s taxable income and resulting in a tax reduction.

The tax reduction occurs because interest expense is considered a business expense deductible for tax purposes. When a lessee records interest expense on their income statement, the lessee can deduct that expense from its taxable income, reducing the amount of tax owed.

It is worth noting that the specific accounting treatment of capital lease payments can vary depending on the lease agreement terms and the applicable accounting standards. The same advice applies here—consult with your accountant to ensure the lease payment is accounted for properly under GAAP standards.

Advantages & Disadvantages

There are several advantages and disadvantages to capital leases, many of which we have mentioned above. Below we’ll briefly summarize the most common so you can refer back to this section quickly if needed.

Advantages of a Capital Lease

  • Lower upfront costs compared to purchasing the asset outright
  • Asset ownership at the end of the lease
  • Fixed lease payments for easier budgeting
  • Potential tax benefits (e.g. deducting lease payments as an expense)

Disadvantages of a Capital Lease

  • Can cost more compared to purchasing the asset outright
  • Very long term commitment
  • Maintenance and repair costs that can add up
  • Limited flexibility in terms of modifying or ending the lease early
  • Risk of obsolescence if the asset becomes outdated before the end of the lease term

Considerations to Make Based on Benefits & Drawbacks

It is important for businesses to carefully consider the advantages and disadvantages of a capital lease, as well as their own financial situation and needs, when deciding whether to enter into a capital lease agreement.

Capital Lease vs. Operating Lease

Operating and capital leases differ in their accounting treatment, lease terms, and ownership of the leased asset. An operating lease is a shorter-term lease where the lessor retains asset ownership, while a capital lease is longer and provides the lessee with some aspects of ownership, which are represented on the balance sheet.

Operating lease payments are fully tax-deductible and are treated as operating expenses. While capital leases also offer some tax benefits, only a portion of the payment is considered tax-deductible. Additionally, the payments are not considered operating expenses.

A capital lease is longer-term, and the lessee effectively owns the leased asset, recording both the leased asset and the lease obligation on its balance sheet. Capital lease payments are structured like loan repayments; only the interest portion is tax-deductible.

Previously, accounting for operating and capital leases differed more significantly under the ASC 840 standard. Operating leases were only accounted for on the income statement, allowing companies to keep them off the balance sheet. Because of this, operating leases were considered a type of off-balance sheet financing.

However, the new ASC 842 standard requires all leases, except short-term ones (under 12 months), to be included on the balance sheet. The lessee must recognize a lease liability and a right-of-use asset under an operating lease agreement, reducing the differences between operating and capital leases in terms of accounting.

Maximizing Efficiency & Sustainability Through Leasing

Leasing can help businesses become more sustainable and fuel growth in several ways. By leasing equipment instead of purchasing it outright, companies can conserve their cash reserves and invest in more sustainable practices.

For example, you could use the money saved by leasing equipment to invest in energy-efficient equipment or implement environmentally-friendly processes, helping you become more sustainable and reduce your carbon footprint.

Leasing equipment can also help companies maximize efficiency. It can help you access the latest and most advanced equipment, which can help your operations become more efficient and effective.

For example, you could lease new machinery that is more energy-efficient or has improved features, reducing waste and improving productivity. By working to maximize efficiency, you can increase your output and reduce costs, which can ultimately fuel growth.

In addition, leasing equipment can provide businesses with more flexibility. Leasing allows businesses to adapt to changing market conditions and technology trends without being tied down to obsolete equipment, helping you stay competitive and grow over time.

Interested in leasing new or refurbished lab equipment? Let us know.