Capital lease

Definition

A capital lease, also known as a finance lease, is a lease agreement that allows the lessee to acquire the benefits and risks of ownership of an asset, even though the legal title remains with the lessor. This type of lease is usually long-term and provides the lessee with the right to purchase the asset at the end of the lease term for a predetermined price. Capital leases are significant because they affect both the lessee's balance sheet and cash flow, as they are typically recorded as assets and liabilities.

5 Must Know Facts For Your Next Test

1. Capital leases must meet specific criteria set by accounting standards, such as transferring ownership by the end of the lease or having a bargain purchase option.
2. The asset acquired through a capital lease appears on the lessee's balance sheet as an asset and simultaneously creates a liability for future payments.
3. Lease payments for a capital lease typically include both principal and interest components, which impact cash flow differently compared to operating leases.
4. Capital leases can provide tax advantages, as lessees can often deduct depreciation expenses and interest payments on their taxes.
5. In contrast to operating leases, capital leases usually lead to higher reported debt levels for lessees, which can affect financial ratios and borrowing capacity.

Review Questions

• What are the main criteria that distinguish a capital lease from other types of leases?
  • A capital lease is distinguished from other types of leases by meeting specific criteria outlined by accounting standards. These include conditions such as transferring ownership of the asset to the lessee at the end of the lease term, containing a bargain purchase option that allows for buying the asset at a significantly lower price, or having a term that covers most of the asset's useful life. If these criteria are met, it requires capitalization on the balance sheet.
• How does recording a capital lease affect a company's financial statements compared to an operating lease?
  • When a company records a capital lease, it must recognize both an asset and a corresponding liability on its balance sheet. This contrasts with an operating lease, which does not require balance sheet recognition. The capital lease affects financial ratios by increasing total assets and liabilities, potentially altering metrics like return on assets or debt-to-equity ratios. Additionally, in terms of income statements, capital leases allow for depreciation expenses and interest expense deductions while operating leases generally only record rent expense.
• Evaluate the long-term implications for a business choosing between a capital lease and an operating lease regarding cash flow management and asset ownership.
  • When evaluating whether to choose a capital lease or an operating lease, businesses must consider long-term cash flow management and their strategies around asset ownership. A capital lease can lead to higher initial cash outflows due to larger payments but allows businesses to own assets eventually, which may be beneficial for long-term operational needs. Conversely, an operating lease can preserve cash flow in the short term but may lead to continual rental expenses without asset ownership. The choice impacts both current financial flexibility and future operational capabilities depending on how critical ownership is for the company’s strategy.

Related terms

operating lease: An operating lease is a lease agreement that is shorter in duration and does not transfer ownership risks and benefits to the lessee, allowing for more flexible use of an asset.

depreciation: Depreciation is the accounting method used to allocate the cost of a tangible asset over its useful life, impacting financial statements and tax obligations.

lessee: A lessee is an individual or business that leases an asset from another party, known as the lessor, under a rental agreement.