Capital Lease

Definition of a Capital Lease

A capital lease (a.k.a. finance lease) is a lease considered to have the economic characteristic of asset ownership. Under US accounting standards, a capital lease is a lease which meets at least one of the following criteria:

1. the lease term is greater than 75% of the asset’s estimated useful life
2. the lease contains a bargain purchase option to buy the equipment less than fair market value.
3. ownership of the asset is transferred to the lessee at the end of the lease term
4. the present value of the lease payments exceeds 90% of the total original cost of the equipment.

Capital Lease Essentials

Benefits of a Capital Lease

A capital lease, much like a loan, will show up on the company’s balance sheet as a liability. This will allow you to depreciate the equipment as your own. The depreciation will lower your taxable income, thus reducing your overall tax liability.

A capital lease differs from a loan because it offers flexibility on the backend. Generally, you will have the option to choose a nominal fixed buyout (anywhere from 1% to 10%). This lowers your monthly payment without having to pay that money upfront with a down payment.

Disadvantages of a Capital Lease

By capitalizing the lease on your balance sheet it will also have an effect on your debt (leverage) ratios in a negative manner. By adding more debt to your balance sheet, banks and other financial institutions will look upon your financial standing less favorably, but no more so than a loan.

It is also important to note that with this type of lease, you are agreeing to purchase the equipment from the beginning of the lease. Unlike some other types of leases, if you choose to return the equipment at the end of the lease, you will not be allowed to do so without paying for it in full.

Types of End of Term Buyouts Associated with a Capital Lease

One Dollar ($1) Buyout

A one-dollar buyout purchase agreement is just that, the lessee pays the lessor $1.00 at the end of the lease term in order to transfer ownership. Having a dollar buyout at the end of term makes the lease look exactly like a term loan of the same term. The payments will be exactly the same.

Fixed Buyout

A fixed buyout is a predetermined amount of money that will need to be paid to the lessor by the lessee at the end of term. Common fixed amounts are 10%, 5%, or 3% of the total equipment value.

Want to know more about a capital lease? Read Getting to Know a Capital Lease