Capital Leases
Candlefocus EditorThe key difference between a capital lease and an operating lease is that the capital lease provides a contractual obligation that makes the lessee the owner in accounting terms, whereas an operating lease does not provide this contractual obligation, and remains an off-balance sheet transaction.
When a capital lease is entered into, the general accounting procedure is for the leased asset to be recorded on the balance sheet and for an associated lease obligation to be recorded as a liability. A legitimate capital lease must include all three of the following criteria:
• Transfer of ownership, meaning at the end of the lease term the lessee obtains sole ownership of the asset • Bargain Purchase Option, meaning there is an option to purchase the asset during the lease period at a pre-determined price that is lower than fair market value • Essential use, meaning that the asset is of recognized economic value and the lessee stands to benefit from its use
Additionally, capital leases are often beneficial for tax purposes, as the lessee is able to claim depreciation deductions and interest expense deductions.
Capital leases have several advantages for businesses. These include the ability to afford expensive and long-term assets; allowing the lessees to take advantage of tax savings by claiming deductions; spreading the cost of the asset over time; and the potential of future ownership of the asset. However, capital leases can also cause financial strain or burden for a business. Since assets are recorded on the balance sheet and the lessee is obligated to purchase the asset in the future, the debt can pre-emptively affect cash flow and liquidity.
Overall, a capital lease is an important instrument, allowing businesses to acquire assets using debt that are recorded on their balance sheet. The decision to enter into a capital lease is significant, and should be made with proper consideration and due diligence.