Legal Definitions - capital lease

A capital lease (also known as a finance lease) is a type of lease agreement that, for financial reporting purposes, is treated as if the lessee (the party leasing the asset) has purchased the asset rather than simply rented it. This classification occurs when the lease agreement effectively transfers most of the risks and rewards of ownership from the lessor (the asset owner) to the lessee.

Because a capital lease is considered a form of asset acquisition, the leased asset appears on the lessee's balance sheet, and the lessee records both depreciation expense for the asset and interest expense on the lease liability over the lease term. This differs significantly from an operating lease, where the asset remains off the lessee's balance sheet, and lease payments are simply expensed as rent.

Here are some examples to illustrate how a capital lease works:

• Example 1: Manufacturing Company and Specialized Equipment

  Imagine "Precision Parts Inc.," a manufacturing company, needs a new, highly specialized robotic arm for its production line. Instead of buying it outright for $1 million, they enter into a 7-year lease agreement. The robotic arm has an estimated useful life of 8 years. The lease payments are structured such that their present value is $950,000. At the end of the 7-year lease, Precision Parts Inc. has the option to purchase the robotic arm for a nominal fee of $100.

  This arrangement is a capital lease because Precision Parts Inc. is effectively acquiring the economic benefits and risks of ownership. The lease term (7 years) covers a substantial portion of the asset's useful life (8 years), the present value of the lease payments is very close to the asset's fair market value, and there's a bargain purchase option. For accounting purposes, Precision Parts Inc. would record the robotic arm as an asset on its balance sheet and recognize depreciation over its useful life, along with an associated lease liability.

• Example 2: Tech Startup and Data Servers

  A rapidly growing tech startup, "CloudBurst Solutions," requires a large number of high-performance data servers to expand its cloud services. Instead of purchasing them, they sign a 5-year lease agreement for servers that have an estimated useful life of 6 years. The lease payments are substantial, and the agreement stipulates that CloudBurst Solutions is responsible for all major repairs and maintenance. Furthermore, at the end of the lease term, ownership of the servers automatically transfers to them.

  This arrangement qualifies as a capital lease. Even though it's called a "lease," CloudBurst Solutions assumes nearly all the benefits and burdens of ownership. The automatic transfer of ownership at the end of the lease term is a key indicator. Consequently, CloudBurst Solutions would record the servers as assets on its balance sheet, reflecting their long-term control and responsibility, and account for depreciation and interest expenses related to the lease.

• Example 3: Hospital and MRI Machine

  "Community Health Hospital" needs a new, state-of-the-art MRI machine, costing $3 million. They enter into a 10-year lease agreement for the machine, which has an estimated useful life of 12 years. The lease payments are calculated such that their present value equals $2.9 million. The hospital is responsible for all insurance, maintenance, and operational costs, and the lease agreement does not include an option to return the machine or purchase it for a nominal fee at the end; rather, the lease payments effectively cover the entire cost of the machine over its useful life.

  This is a capital lease because the hospital effectively finances the acquisition of the MRI machine through the lease. The lease term covers a significant portion of the machine's economic life, and the present value of the lease payments is substantially all of the asset's fair market value. The hospital bears the risks and rewards of ownership, such as maintenance and insurance, as if they owned it. Therefore, the MRI machine would appear as an asset on the hospital's financial statements, and a corresponding lease liability would be recorded.