Capital Lease

A capital lease, also known as a finance lease, is a long-term leasing arrangement in which the lessee (user of the asset) effectively gains ownership-like rights and responsibilities over the leased asset, even though legal ownership remains with the lessor (owner). It is treated as an asset acquisition for accounting purposes, meaning that the leased asset and the corresponding lease liability are recorded on the lessee’s balance sheet.
The concept of a capital lease is vital in corporate finance and accounting as it bridges the gap between ownership and rental. It allows businesses to use high-value assets such as machinery, buildings, or vehicles without making an outright purchase, thereby spreading the cost over time while still recognising the economic substance of ownership.

Nature and Concept

In a capital lease, the lessee assumes most of the risks and rewards associated with ownership. This distinguishes it from an operating lease, where the lessor retains ownership benefits and the lessee merely pays for temporary use.
Under accounting standards such as International Financial Reporting Standards (IFRS 16) and US GAAP (ASC 842), leases that transfer substantially all ownership risks and benefits to the lessee are classified as capital (or finance) leases.
A capital lease, therefore, has the characteristics of both a purchase and a financing agreement — the asset is treated as being financed through debt and is gradually written off through depreciation and interest payments.

Key Features of a Capital Lease

• Long-term Duration: Typically covers most of the economic life of the asset.
• Transfer of Ownership: The lease may provide for the transfer of ownership to the lessee at the end of the term.
• Bargain Purchase Option: The lessee often has the option to purchase the asset at a significantly reduced price after the lease term.
• Asset Control: The lessee has full control over the asset and is responsible for maintenance, insurance, and taxes.
• Balance Sheet Recognition: Both the asset and the associated lease liability are recorded on the lessee’s balance sheet.
• Interest and Depreciation: Lease payments are split between interest expense and principal repayment, similar to loan accounting.

Criteria for Classification

Under traditional accounting guidelines, a lease is classified as a capital lease if it meets any one of the following conditions:

1. Transfer of Ownership: Ownership of the asset is transferred to the lessee at the end of the lease term.
2. Bargain Purchase Option: The lessee can buy the asset at a price significantly below fair market value.
3. Lease Term: The lease period covers 75% or more of the asset’s estimated economic life.
4. Present Value of Payments: The present value of lease payments equals or exceeds 90% of the asset’s fair market value at the lease’s inception.

If none of these conditions are met, the lease is generally treated as an operating lease.

Accounting Treatment for Lessee

For the lessee, a capital lease is treated similarly to purchasing an asset through financing. The accounting entries include:

1. At Inception:
   • Record the leased asset and a corresponding lease liability at the present value of future lease payments.

   Example Entry:

   • Debit: Leased Asset (at present value)
   • Credit: Lease Liability
2. During Lease Term:
   • Depreciate the asset over its useful life or lease term.
   • Record periodic lease payments, separating interest expense from principal repayment.

   Example Entries:

   • Debit: Interest Expense
   • Debit: Lease Liability
   • Credit: Cash (Lease Payment)
   • Debit: Depreciation Expense
   • Credit: Accumulated Depreciation
3. At Lease End:
   • If ownership is transferred, the asset remains on the balance sheet.
   • If returned, it is removed, and any gain or loss is recognised.

This accounting treatment ensures that the financial statements reflect both the use of the asset and the obligation to pay for it over time.

Accounting Treatment for Lessor

For the lessor, a capital lease is recognised as a lease receivable rather than as an asset:

• The asset is removed from the lessor’s books and replaced by a receivable equal to the present value of future lease payments.
• The lessor recognises interest income over the lease term as payments are received.

Advantages of a Capital Lease

• Ownership Benefits: The lessee enjoys the economic benefits of asset ownership, including control and use.
• Tax Advantages: Interest and depreciation are deductible expenses, reducing taxable income.
• No Large Initial Payment: Allows acquisition of costly assets without a heavy upfront investment.
• Improved Asset Management: Useful for financing capital-intensive projects.
• Predictable Costs: Fixed lease payments aid in budgeting and financial planning.

Disadvantages of a Capital Lease

• Balance Sheet Impact: Increases liabilities and may affect financial ratios such as debt-to-equity.
• Commitment Risk: The lessee is bound by the lease for its entire term, even if the asset becomes obsolete.
• Maintenance Responsibility: The lessee must bear upkeep and repair costs.
• Complex Accounting: Requires detailed calculation and disclosure of interest, depreciation, and liability.

Difference Between Capital Lease and Operating Lease

With the introduction of IFRS 16 and ASC 842, the distinction between operating and capital leases has narrowed, as most leases now appear on the balance sheet to enhance transparency.

Example

A company leases machinery worth ₹10,00,000 for five years, paying ₹2,50,000 annually. The lease includes a bargain purchase option of ₹50,000 at the end of the term. Since ownership transfer and a favourable purchase option exist, the lease qualifies as a capital lease.

• The lessee records the machinery as an asset worth the present value of payments and depreciates it over its useful life.
• Each annual payment is divided into interest and principal components for accounting purposes.

At the end of the lease, the lessee exercises the purchase option and continues using the asset as an owned resource.

Economic Significance

Capital leases play an important role in corporate finance, particularly in industries requiring expensive assets such as aviation, manufacturing, and infrastructure. They allow firms to access capital equipment efficiently, preserving liquidity and balancing financial risk.
By aligning accounting with economic reality, capital leases ensure that balance sheets more accurately reflect long-term commitments and asset utilisation.