Capital Lease Agreement
A Capital Lease Agreement is a long-term lease arrangement that allows the lessee (the party leasing the asset) to gain a significant portion of the benefits and risks of ownership of the leased asset without actually owning it. This type of lease is often treated as a purchase for accounting purposes, meaning that the lessee must record the asset on their balance sheet, along with a corresponding liability for the lease obligation.
In a Capital Lease Agreement, several criteria typically determine whether the lease qualifies as a capital lease:
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Transfer of Ownership: The lease must state that ownership of the asset will transfer to the lessee at the end of the lease term.
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Bargain Purchase Option: The lessee has the option to purchase the asset at a price significantly lower than its fair market value at the end of the lease term.
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Lease Term: The lease term must cover a substantial portion (generally 75% or more) of the asset’s useful life.
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Present Value: The present value of the lease payments must equal or exceed 90% of the fair market value of the asset at the beginning of the lease.
An example of a Capital Lease Agreement could involve a company leasing heavy machinery. Assuming the lease lasts for most of the machinery’s useful life, includes a bargain purchase option, and meets the other criteria, the company would record the machinery as an asset on its balance sheet and also recognize a liability for the lease payments. This arrangement allows the company to utilize the equipment while benefiting from potential tax deductions related to depreciation and interest expense.
In contrast, a lease that does not meet any of these criteria is typically classified as an Operating Lease, which does not result in asset ownership or liability recording on the lessee’s balance sheet.
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