Capital Lease

Definition of Capital Lease

Capital lease or the financial lease is a type of lease where the ownership is transferred to the lessee, and the leased asset is recognized as an asset in the balance sheet by the lessee as a period of lease almost covers more than 75 percent of the life of the asset with the present value of lease payments almost near to the fair value of the asset and the lessee is given option to purchase the asset at the end of lease period.

Explanation

A capital lease is also termed a finance lease because, in the capital lease, the ownership rights transferred to the lessee, and the lease payments are considered loan payments, i.e., EMI instead of rent interest is recognized in the profit and loss account. The lessee in the finance lease also claims the depreciation. For a lease to be termed as a capital l, the lessee has some conditions or criteria to be fulfilled. It is a contract entitling the terms for use of the asset and other characteristics which helps in accounting.

How does It Work?

Before few years, all leases were termed as operating lease as one party pay a lease to another for use of asset but Financial Accounting Standard Board has noticed that in some of the cases the lease agreement is more than one year or for the term which almost covers the life of the asset. So, in 2016 the Financial accounting standard board has made an amendment to its accounting rules citing companies to capitalize all lease agreements having term greater than 1 year in financial statements the reason being if the lease term is greater than 1 year then the benefit of the lease will also be more than 1 year hence matching principle is to be applied by capitalizing lease.

To qualify as a capital lease, the lease arrangement must satisfy any of the Financial Accounting Standard Board criteria.

Criteria for Capital Lease

For a lease to be termed as a capital lease, at least one of the following criteria is to be fulfilled:

• The lease term should cover greater than 75% of the life of the asset.
• Lessee has been given an option to purchase the asset at the end of the lease term.
• The Lease must contain the bargain for the purchase price at the end of the lease term, and the price might be less than the market price.
• The Present Value of lease payments should be greater than 90 percent of the asset’s market value.

Example of Capital Lease

Company A Ltd. enters into a lease agreement with the government to use the governmental property as the Land and building. The Term of the lease was 25 years, and the yearly lease payments were $ 300,000 per year for 25 years to be paid at the end of each year. The fair value of the property is $ 3,550,000. The rate of interest prevailing in the market is 7%. Determine whether the lease is a capital lease or an operating lease?

Solution:

For a lease to be termed as capital lease one of the criteria as mentioned in criteria for capital lease is to be fulfilled As the useful life of an asset is not determined hence, we cannot calculate whether useful life covers more than 75 percent of the lease term and it is also not defined whether the lessee has the option to buy the leased property at the end of the lease term. Hence, we will calculate the present value of lease payments to determine whether the lease is qualified to be a capital lease.

Year	Lease Payment	Present Value Factor	Net Present Value
1	300,000	0.93	280,373.83
2	300,000	0.87	261,000.00
3	300,000	0.82	246,000.00
4	300,000	0.76	228,000.00
5	300,000	0.71	213,000.00
6	300,000	0.67	201,000.00
7	300,000	0.62	186,000.00
8	300,000	0.58	174,000.00
9	300,000	0.54	162,000.00
10	300,000	0.51	153,000.00
11	300,000	0.47	141,000.00
12	300,000	0.44	132,000.00
13	300,000	0.41	123,000.00
14	300,000	0.39	117,000.00
15	300,000	0.36	108,000.00
16	300,000	0.34	102,000.00
17	300,000	0.32	96,000.00
18	300,000	0.29	87,000.00
19	300,000	0.28	84,000.00
20	300,000	0.25	75,000.00
21	300,000	0.24	72,000.00
22	300,000	0.22	66,000.00
23	300,000	0.21	63,000.00
24	300,000	0.19	57,000.00
25	300,000	0.18	54,000.00
			3,481,373.83

Present Value of Lease Payments / Fair Value of Property

= 3481373.83 / 3550000

= 0.98

= 98%

As the Lease payment covers 98% of the fair value of an asset, the lease is to be termed as a capital lease.

Capital Lease Obligation

• Lessor is entitled to receive the lease payments
• Repairing and maintain the asset is the responsibility of the lessee.
• Risk related to assets and future liabilities related to the asset is to be borne by the lessee.
• It enables the lessee to purchase the asset without spending large amounts by a single payment.
• Capital lease obligation is similar to hire purchase contract and covers the features of purchase of an asset.

Difference Between Capital Lease and Operating Lease

• It is the lease contract for the use of an asset and a period covers almost more than 75 percent of the life of the asset, whereas an operating lease is for a shorter term which is less than 1 year.
• In a capital lease, the asset is recorded in the balance sheet, and lease payments are treated as payments for the financing of the asset, whereas in the operating lease, the lease is considered as the normal rental agreement.
• In capital lease option for transfer of ownership rights is there at the end of the lease term, whereas in an operating lease, no option for transfer of ownership rights is there at the end of the lease term.
• Only the interest component of lease payments is transferred to the profit and loss account in case of a capital lease, whereas in the case of an operating lease whole of the lease payments is charged to the profit and loss account.

Advantages

Some of the advantages are given below:

• The lessee claims benefits like depreciation of assets, repairs on the assets.
• Lessee has the option to purchase the asset at the end of the lease term at a price that might be less than the market price.
• It is one of the cheaper ways to purchase the asset.
• A lessee can recognize the asset it has on the balance sheet.

Disadvantages

Some of the disadvantages are given below:

• As capital lease payments are treated as debt, the debt-equity ratio becomes high, affecting the investors.
• The responsibility of maintenance of asset is transferred to the lessee, which increases the cost.
• It is possible that at the end of the lease period, the asset become absolute.

Conclusion

It is the lease arrangement in which the lessor and lessee enter into an agreement for the use of an asset that almost covers the life of the asset. There are certain criteria to be satisfied for treating the lease as a capital lease. It is different from operating lease as in capital lease; lease payments are considered loan repayments, whereas, in the operating lease, the lease payments are considered rental payments. As the lessee bears the maintenance cost in the capital lease, the cost of the lessee is increased.

Recommended Articles

This is a guide to Capital Lease. Here we also discuss the definition and criteria for capital lease along with advantages and disadvantages. You may also have a look at the following articles to learn more –

1. Capital Lease vs Operating Lease
2. Capital Budgeting Importance
3. Working Capital Management Importance
4. Return on Invested Capital