A capital lease functions similarly to a rent-to-own agreement where a business leases an asset but treats it as if purchased for accounting and tax purposes. Under the Accounting Standards Codification (ASC) 842, the term “capital lease” is largely replaced by “finance lease,” though both terms are still used interchangeably.
Key Characteristics of a Capital (Finance) Lease
When a company enters a finance lease, the leased asset appears on the balance sheet as an asset, and the lease payments generate a liability. Unlike an operating lease that records lease payments as rental expenses, a finance lease breaks down expenses into depreciation of the asset over its useful life and interest expense on the lease obligation.
Determining a Finance Lease: The Five Criteria
A lease qualifies as a finance lease if it meets any one of these five tests:
- Ownership Transfer: The lease transfers ownership of the asset to the lessee by lease end.
- Bargain Purchase Option: The lease allows purchasing the asset below fair market value.
- Lease Term Length: The lease term is 75% or more of the asset’s economic life.
- Present Value: The present value of lease payments is 90% or more of the asset’s fair market value.
- Specialized Asset: The asset is so specialized no alternative use exists for the lessor after lease expiry.
These criteria are established in accounting guidance such as ASC 842 and backed by resources like Investopedia’s finance lease overview.
Example
A café leasing an espresso machine costing $15,000 for 4 years (asset life 5 years) meets the 75% lease term criterion, classifying the lease as a finance lease. The café records the machine as an asset and the lease payments as a liability, with expenses split between depreciation and interest.
Capital Lease vs. Operating Lease
| Feature | Finance (Capital) Lease | Operating Lease |
|---|---|---|
| Balance Sheet Impact | Recorded as asset and liability | Typically off balance sheet (right-of-use noted) |
| Expense Recognition | Depreciation + Interest expense | Lease/rent expense |
| Ownership Risks | Lessee assumes risks and benefits | Lessor retains ownership and risks |
| Usage Objective | Long-term use of essential assets | Short-term or frequently replaced assets |
For more on lease types and their financial impact, see our articles on Leaseback Financing and Off-Balance-Sheet Financing.
Why Use a Capital (Finance) Lease?
Businesses choose finance leases to acquire valuable equipment without upfront capital, gain potential tax benefits through interest and depreciation deductions, and build equity as if purchasing the asset. However, these leases increase liabilities on financial statements, which may affect borrowing capacity.
Frequently Asked Questions
Is a capital lease considered debt?
Yes. The lease obligations appear as liabilities (debt) on the balance sheet.
Can I deduct capital lease payments on taxes?
You deduct the depreciation and interest portions separately but not the full lease payment like you would with operating leases.
How is a capital lease different from a loan?
A loan transfers legal ownership upfront, but a capital lease treats the asset as owned for accounting even if legal title transfers later.
For authoritative information, visit IRS.gov or explore detailed accounting guidelines under ASC 842.
This updated glossary entry ensures clarity, accuracy, and highlights relevant related topics with internal links, making it a helpful resource for FinHelp.io readers.