Capital Lease
A capital lease, also referred to as a financial lease, is a contract entitling a renter to the temporary use of an asset that is accounted for as an owned asset. It is a long-term financial agreement where the lessee takes on the characteristics of an owner, along with the associated risks and rewards. Under a capital lease, the leased asset is treated for accounting purposes as if it were actually owned by the lessee and is recorded on the balance sheet as such. Similar to taking a loan, the lessee pays the lessor at regular intervals over a specified timeframe, with the potential for asset ownership or acquisition as per predetermined terms. Essentially, a capital lease is treated as a purchase of an asset under generally accepted accounting principles (GAAP), while an operating lease is handled as a true rental agreement.
CAPITAL LEASE VS. OPERATING LEASE
While a capital lease is treated as an asset on the lessee’s balance sheet, an operating lease remains off the balance sheet.
Conceptually, a capital lease can be thought of as ownership of a rented asset, while an operating lease is like renting any type of asset in the normal course.
The notable difference between a capital lease and an operating lease is that for an operating lease, the asset must be returned to the owner at the end of the lease term.
CHARACTERISTICS
Ownership transfer at the end of the lease term.
The lease agreement typically outlines the conditions under which ownership is transferred. It marks a strategic departure from other leasing arrangements where ownership remains vested with the lessor.
Bargain purchase option.
This facet extends the lessee a unique advantage: The opportunity to acquire the leased asset at a notably reduced price compared to its prevailing fair market value at the end of the lease term.
Longer lease term.
Capital leases are characterized by their extended lease terms. The period of the lease encompasses at least 75% of the useful life of the asset.
Present value.
The present value of the minimum lease payments required under the lease is at least 90% of the fair value of the asset at the inception of the lease.