What is a capital lease?

A capital lease is defined as a lease that is treated as an asset purchase for accounting purposes. This means that the lessee (the party leasing the asset) records the leased asset on its balance sheet as if it owns the asset. The associated lease liability is also recorded, representing the obligation to make lease payments over the term of the lease.

This treatment is applicable when certain criteria are met, which can include conditions such as transferring ownership of the asset to the lessee at the end of the lease term, the lease term being a significant portion of the asset's useful life, or the present value of lease payments being substantially equal to or greater than the asset’s fair market value.

By treating the lease this way, businesses can account for their leased equipment or property in a manner that reflects the economic reality of their use of the asset, leading to more accurate financial reporting and analysis. This treatment is contrasted with operating leases, where the lease does not get recorded on the balance sheet in the same way, and rental expenses are recorded on the income statement instead.