Capital Lease is Defined as Follows:
A lease that is considered to have the economic characteristics of asset ownership. That definition is provided by Investopedia. The capital lease is treated as a purchase for accounting purposes. A “true lease”, or operating lease is expensed, rather than depreciated. This is not true in capital leasing agreements. Rather, the item being leased is depreciated and the interest portion of the lease payment is expensed.
Equipment Leases are Generally all Capital Leases
You can determine if a lease is a capital lease quite easily. A capital lease must meet at least one of four criteria:
- Title of the asset passes automatically from the lessor to the lessee at end of the lease term
- Lease contains a bargain purchase option under which the lessee may acquire the leased-asset at less than its fair market value at the end of lease term
- Lease term is for a period longer than the 75 percent of the estimated economic life of the asset, or
- The present value of the lease payments is greater than 90 percent of the fair market value of the asset at the beginning of the lease term.
Capital Leases are Fully Amortized and Non-Cancelable
A capital lease depends much less on residual value and more on the asset value. In other words, a capital lease resembles an installment loan in terms of total payments being more than the initial asset value. They are non-cancelable in the same manner that a loan is non-cancelable. The Lessor’s only responsibility is to finance the asset. The Lessee pays insurance, sales tax and property tax.
The Lessor in a Capital Lease is Not the Dealer
The capital lease is also known as a finance lease. The lessor is only the financier of the equipment. The lessor has no responsibility in providing service, even when service is bundled in the lease.
Accounting For a Capital Lease
You must depreciate the leased asset and include it in your balance sheet, for capital leasing. To Contrast, an operating lease allows expensing of the entire lease payment, much like a rental agreement. For Capital leases, you can only expense the interest paid on the lease instead of the entire payment. You should discuss this with your accountant to determine the tax treatment of this financing arrangement for your situation.