Last Updated on
February 25, 2025
By
Excedr
For businesses that need equipment, vehicles, or other essential assets but want to avoid large upfront costs, a capital lease can be a strategic financing option. This type of lease provides long-term access to critical assets while offering predictable payments and potential tax advantages. Unlike short-term rental agreements, capital leases are structured for businesses that require stability, control, and the ability to eventually own the asset.
In this guide, we’ll break down how capital leases work, their key benefits, and important factors to consider—helping you decide if this financing option aligns with your business needs.
A capital lease, now referred to as a finance lease under updated accounting standards, is a long-term lease agreement where the lessee assumes ownership-like responsibilities for the asset. Unlike an operating lease, which functions more like a rental, a finance lease allows businesses to use and control the asset as if they own it, even though legal ownership remains with the lessor during the lease term.
Under this lease structure, the lessee is responsible for maintenance, insurance, and associated costs, meaning they bear the financial obligations of asset ownership. The asset is also recorded on the lessee’s balance sheet as both an asset and a liability, with lease payments divided between interest expense and principal reduction. This accounting treatment provides potential tax benefits while ensuring long-term access to essential equipment.
These differences make capital leases a preferred choice for businesses investing in equipment, vehicles, or machinery that they plan to use for an extended period, while operating leases work better for companies prioritizing agility and regular upgrades.
A lease is classified as a capital lease if it meets at least one of the criteria established by the Financial Accounting Standards Board (FASB)—the organization responsible for setting U.S. accounting standards. Recognized by the Securities and Exchange Commission (SEC), FASB regularly updates these standards to reflect economic realities and provide useful financial information to investors and stakeholders.
For a lease to qualify as a capital lease, it must meet at least one of the following criteria:
If a lease meets any one of these criteria, it qualifies as a capital lease for financial reporting and accounting purposes. This classification requires the lessee to record the asset on their balance sheet, reflecting a commitment to long-term use and aligning with the economic substance of ownership.
A capital lease has several key features that distinguish it from other lease types:
Each of these characteristics reinforces the ownership-like nature of a capital lease, making it a strategic financing tool for businesses that need long-term access to essential assets.
One of the key distinctions of a capital lease is its balance sheet treatment, which differs significantly from an operating lease. Under IFRS 16 and ASC 842, capital leases must be recorded as both an asset and a liability, reflecting the lessee’s long-term financial commitment. This is generally how a capital lease will appear on the balance sheet:
Now let's review an example of capital lease accounting. Consider a business that enters a five-year capital lease for a machine valued at $100,000 with annual payments of $25,000, due at the beginning of each year. Using a 10% discount rate, the present value of the lease payments is $101,491.
On the lessee’s balance sheet, the following entries are made:
Over time, lease payments are divided into:
This accounting treatment aligns finance leases more closely with asset ownership, impacting key financial metrics such as debt ratios, return on assets (ROA), and EBITDA.
Capital leases can also offer financial and tax advantages. The way lease payments are structured—split between principal reduction and interest expense—can impact a company’s tax liabilities and overall financial strategy. Let's go over an example of how lease payments are treated. Each lease payment is divided into two components:
Because interest expenses are tax-deductible, businesses can reduce their taxable income, making leasing an effective financial strategy for cash flow management. Additionally, capital leases may allow businesses to depreciate the asset over time, further contributing to tax savings.
Now let's review an example. If a company leases a $100,000 machine under a capital lease and the first year's lease payment includes $5,000 in interest, the company can deduct that amount as an expense on its income statement, reducing taxable income. The remaining portion of the lease payment reduces the lease liability on the balance sheet.
By structuring lease payments in this way, businesses can benefit from both tax deductions and gradual liability reduction, making capital leases an attractive option for companies looking to manage finances strategically.
When acquiring equipment or other assets, businesses often compare capital leases to traditional loans. While both financing options provide long-term access to assets, they differ in ownership structure, financial impact, and flexibility. Let's review the key differences between capital leases and loans:
Ownership:
Balance sheet impact:
Payments & tax treatment:
Flexibility:
Choose a capital lease if you:
Choose a loan if you:
Both financing options have advantages depending on your business goals, budget, and asset needs. If you’re still deciding between leasing options, check out our guide on how to choose between a capital lease and an operating lease.
A capital lease can be a smart financing choice, but overlooking key details can lead to unexpected costs and limitations. To secure the best terms and avoid financial pitfalls, businesses should carefully review lease terms, financial responsibilities, and the long-term value of the asset to ensure the lease aligns with their growth strategy and financial goals.
Not all capital leases automatically transfer ownership at the end of the term. If you expect to own the asset, confirm whether you’ll need to pay a nominal purchase fee or meet additional requirements.
Since capital leases shift maintenance and insurance responsibilities to the lessee, failing to account for repair expenses, insurance premiums, and upkeep costs can lead to financial strain.
Leasing equipment that could become obsolete before the lease term ends can leave businesses stuck with outdated technology. Consider how quickly the asset might depreciate and whether a shorter lease term or an operating lease would be more appropriate.
Businesses often assume lease terms are non-negotiable, but many leasing companies are open to adjusting payment schedules, buyout options, or contract flexibility. Always negotiate to ensure the lease fits your company’s financial strategy.
Since capital leases are recorded on the balance sheet, they can impact debt ratios, financial statements, and tax deductions. Businesses should consult with accounting professionals to fully understand how the lease will affect their finances.
A capital lease provides businesses with a structured way to acquire assets, but like any financing option, it comes with both advantages and drawbacks. Here’s a quick summary:
Businesses and labs should carefully weigh these factors to determine if a capital lease aligns with their financial strategy and long-term operational needs.
A capital lease, now referred to as a finance lease, can be a valuable financing option for businesses looking for long-term asset control, predictable costs, and potential ownership at the end of the lease term. However, it also comes with financial responsibilities, including maintenance, insurance, and the risk of asset obsolescence. Carefully evaluating your business goals, budget, and equipment needs will help determine whether a capital lease is the right fit.
For businesses seeking greater flexibility, lower upfront costs, and no maintenance obligations, an operating lease may be a more strategic alternative. Unlike capital leases, operating leases do not require asset ownership responsibilities—instead, they provide access to the latest equipment while preserving cash flow and reducing financial risk.
At Excedr, we specialize in operating leases, offering businesses a smarter way to acquire cutting-edge equipment without the financial burden of ownership. If you're deciding between leasing options, check out our guide on capital leases vs. operating leases.
Want to learn more about how Excedr’s operating lease program can help your business? Get in touch with our team today to explore leasing solutions tailored to your needs.
