Updated July 14, 2023
Definition of Capital Lease
A 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 are 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 a capital l, the lessee has some conditions or criteria to fulfill. It is a contract entitling the terms for using the asset and other characteristics, which helps in accounting.
How Does It Work?
Before a few years, all leases were termed operating leases as one party paid a lease to another for the use of an asset. Still, Financial Accounting Standard Board has noticed that in some cases, the lease agreement is more than one year or for a term almost covering the asset’s life. So, in 2016 the Financial accounting standard board made an amendment to its accounting rules, citing companies to capitalize all lease agreements having terms 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.
The lease arrangement must satisfy any of the Financial Accounting Standard Board criteria to qualify as a capital lease.
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 over 75% of the asset’s life.
- Lessee has been given the 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, which might be less than the market price.
- The Present Value of lease payments should exceed 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 lease term was 25 years, and the yearly lease payments were $ 300,000 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 a capital lease, one of the criteria mentioned in the criteria for a capital lease is to be fulfilled. As the useful life of an asset is not determined, 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 qualifies as 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 a capital lease.
Capital Lease Obligation
- Lessor is entitled to receive the lease payments
- Repairing and maintaining the asset is the responsibility of the lessee.
- The lessee will bear risk related to assets and future liabilities related to the asset.
- It enables the lessee to purchase the asset without spending large amounts with a single payment.
- Capital lease obligation is similar to a hire purchase contract and covers the features of the 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 75 percent of the asset’s life, whereas an operating lease is for a shorter term, 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. In contrast, the lease is considered the normal rental agreement in the operating lease.
- The capital lease option for transfer of ownership rights is at the end of the lease term, whereas in an operating lease, no option for transfer of ownership rights is at the end.
- 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 are charged to the profit and loss account.
Advantages
Some of the advantages are given below:
- The lessee claims benefits like depreciation of assets and repairs on the assets.
- Lessee can 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 for maintenance of the asset is transferred to the lessee, which increases the cost.
- At the end of the lease period, the asset may 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 asset’s life. There are certain criteria to be satisfied for treating the lease as a capital lease. It is different from an 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 lessee’s cost is increased.
Recommended Articles
This is a guide to Capital Lease. Here we also discuss the definition and criteria for a capital lease, its advantages, and disadvantages. You may also have a look at the following articles to learn more –
