A Brief Introduction About the Capital Lease
Purchasing is different from leasing. When a party doesn’t want to buy something but needs it, he or she considers leasing. A lease can be of two types. One is a Capital Lease, and the other is Operating Lease. Traditionally, when you lease something, you don’t own it. There are still a buyer and a seller. The seller is known as lessor, and the buyer is known as lessee.
In this lease, the lessee owns the rights of a business entity or business equipment. He also gets ownership rights while the finances are maintained in the company’s balance sheet as an asset. Capital Leases are used for the long term. Operating Lease, on the other hand, is for the small-term and doesn’t give the lessee the benefits of ownership. It involves off-balance-sheet financing.
In Capital Lease, the assets get recorded in the ledger of the lessee as fixed assets. The lessee records only the interest portion as expenses. In the case of Operating Lease, entire lease payments get registered as an expense. An agreement that lists down all the information and clauses of a capital lease is known as the Capital Lease Agreement.
Another name of Capital Lease Agreement is The Lease-Purchase Agreement and Finance Lease Agreement.
Who Takes the Capital Lease? – People Involved
Like any other lease agreement, this agreement also involves a seller and a purchaser or a buyer. The purchaser is called a lessee in terms of the business lease, and the seller is called a lessor. A seller or a lessor can be an individual, a bank, or a leasing organization. On the other hand, a lessee can be real estate, transportation, construction, agriculture, etc.
Purpose of the Capital Lease – Why Do You Need It?
For both Capital Lease and Operating Lease, certain criteria are needed to be met. Capital Lease requirements are particular. Below are a few criteria, if one of them is met, the lease will be Capital Lease –
- The lessees have an option of purchasing the assets at the end of the term
- The lessees are given the ownership rights of the assets
- Lease term exceeds 75% of the asset’s economic life
- The present value of payments is 90% more than asset’s fair market value
For this lease to operate, one of these Capital Lease Criteria has to be present.
Why is this agreement chosen over Operating Lease? Before signing any of the agreements, both parties must understand the difference between Capital Lease Vs. Operating Lease.
Here are some of the reasons why you need Capital Lease –
- It is cost-effective in comparison to purchasing assets
- It can be used for long term leasing
- It could be helpful if the items or assets leased, aren’t obsolete
- Provides the lessee with benefits and drawbacks of ownership
- The assets or items can be purchased in the end, lower than the market rate
- Tax deductions can be claimed, and tax on income can be reduced
- Lessee is allowed to claim depreciation on the asset
Contents of the Capital Lease – Inclusions
A Capital Lease Agreement is an essential financial document for both parties involved. Depending on the industry, the agreement could differ; however, the theme of the agreement remains standard. This agreement is legally binding and should contain all the details about the lease.
The agreement should include the necessary details of both the lessor and lessee. Basic details include names, addresses, phone numbers, etc. of both the parties. As discussed above, both parties can be full-fledged companies or organizations.
Further, the content of the agreement will depend on the industry and asset type. The agreement must have all the details of the assets. Assets are one of the most important entities of this whole agreement. Thus, both parties should describe the assets in detail in the agreement. For example, in the case of machinery, the agreement must include the type of machine, size of it, its manufacturer detail, its built-in dates, etc. It should also include the usage of the machinery.
The agreement must include the details of any third party that is involved. Moving forward, the agreement would have all the important details related to the lease, such as lease period, interest rate, monthly rent, etc. It should have the details of dispute resolution methods and termination policy. It should also specify the details of governing laws. It is always better to include insurance policy, warranty details, and terms and conditions for wear and tear.
Like all other agreements, this agreement also should answer all the important questions during the lease and should make sure there is a fair solution for the cases of default and breach.
How to Draft the Capital Lease?
Lease agreements describe the relationship between a lessor and lessee. For instance, in a rent lease agreement, the relationship is between a landlord and a tenant. Before drafting any of these documents, mutual understanding and discussions with open-mindedness are required. Both parties should discuss all the terms and conditions of the agreement. You should also understand each other’s responsibilities and obligations. It is only after this process that you should start drafting the agreement.
This agreement is a financial document, either of the parties or both may have some doubts regarding finances and money. You can also seek an expert’s help to draft the agreement. An expert can help you understand the terms, conditions, provisions, and clauses.
Both parties should also make sure that the criteria for capital lease are met. The lessee should be clear if he or she wants to keep the assets on reaching the endpoint of the contract. As discussed above, a lessee always has the choice of doing so, as per this kind of lease. This lease also gets used in determining taxes. Thus parties should be additional cautious. These are long term leases, so the agreement must also have a renewal clause added in it.
Negotiation Strategy
There is always scope for some negotiations between two parties. Especially in the case of financial lease agreements, there is always a mutual understanding between two people or two organizations. The lessee is advised to have a negotiation strategy in place to ensure lesser payment of rent or less interest rate. The lessee can also own the asset in the end at a lower price if negotiations are made in the right ways.
Benefits and Drawbacks of the Capital Lease
There are always benefits and drawbacks to any agreement. It is a long-term financial agreement, but it also has some drawbacks. However, if an agreement is used cautiously, keeping everything in mind, the drawbacks and their effects can be reduced. But, first here are a few benefits of this agreement –
- The assets are shown in the balance sheet of the lessee. Thus he or she can claim depreciation.
- The lessee also has to pay interest, which in turn works as an expense and results in reduced taxable income.
- The taxable income of a lessee or his company can be reduced.
- The lessee has the option of owning or purchasing the assets in the end at a much lower value.
- There is no risk of obsolescence if the lessor takes back the assets.
Here are a few drawbacks of this lease –
- The risks are higher
- There is a possibility of holding obsolete assets
- For a lessee or his company, the maintenance cost can get high
- The balance sheet reflects a lot of debt
What Happens in Case of Violation?
Both parties should discuss the governing law and dispute resolution methods before signing the agreement. It is only after both parties understand each of these terms, they can seak the agreement. Dispute resolution, termination, penalty, etc. can be done only as per the agreement signed between both parties. However, in the case of a bigger breach, both parties can take the help of a third party or court. The agreement protects both parties from any wrongdoings and losses. Governing laws(1) vary from state to state, but each state has some laws to protect the rights of lessor and lessee.
Capital Lease definition can be a little complicated for some, but with thorough research and with the help of an expert, the agreement can be drafted easily. You have different kinds of samples capital agreements available for this. Both Capital and Operating Leases are important financial documents that must inclusive of all clauses, terms, and conditions. The agreement must specify all the obligations and responsibilities explicitly. Thus, you must choose the one that suits you the best. The agreement should also give a dispute resolution method for any anticipated problem.