Capital Lease: Criteria, Accounting, and Financial Impact

What Is a Capital Lease?

A capital lease, also referred to as a finance lease, is a contract that allows a lessee to use an asset while transferring most of the ownership benefits and risks from the lessor to the lessee. Unlike a capital lease, an operating lease allows access to an asset. However, it doesn’t offer ownership rights and is treated differently in accounting.

To qualify as a capital lease, the agreement must meet at least one of several criteria, such as the transfer of ownership by the end of the lease, the option to purchase the asset at a bargain price, a lease term that spans most of the asset’s economic life, and lease payments that closely reflect the asset’s fair value. When at least one of these conditions is met, the lessee must account for the lease as if it owns the asset.

The Financial Accounting Standards Board (FASB) made changes in 2016 and 2021 to accounting procedures related to capital leases and their effect on financial statements.

How to Account for a Capital Lease in Financial Statements

A capital lease requires the lessee to record the leased asset and associated liability on their balance sheet if the lease meets specific criteria. Essentially, a capital lease is treated as a purchase of an asset under generally accepted accounting principles (GAAP), while an operating lease is handled as a true rental agreement. Capital leases impact a company’s financial statements, affecting interest expense, depreciation expense, assets, and liabilities.

To qualify as a capital lease, a lease contract must satisfy any of the following four criteria:

1. The lease term is 75% or more of the asset’s useful life.
2. The lease contains a bargain purchase option, allowing the lessee to buy the asset for less than its fair market value.
3. The lessee must gain ownership at the end of the lease period.
4. The present value of lease payments must be greater than 90% of the asset’s market value.

 In 2016, the Financial Accounting Standards Board (FASB) changed the rules to require companies to record leases longer than one year on financial statements. This took effect on Dec. 15, 2018, for public companies and Dec. 15, 2019, for private companies. The change was made because companies used operating leases off the balance sheet, hiding their true debt levels.

In 2021, the FASB issued an update, requiring lessors to classify certain leases with variable payments as operating leases if they would otherwise be classified as sales-type or direct financing leases and result in a selling loss at the start. Effective from December 15, 2021, these changes refine lease accounting standards and impact how companies manage lease-related financials.

Comparing Capital Leases to Operating Leases

 An operating lease, unlike a capital lease, allows the use of an asset without ownership rights.

Operating leases were once kept off the balance sheet, so assets and future rent liabilities didn’t appear there. This practice kept companies’ debt-to-equity ratios low by hiding billions in assets and liabilities.

However, this changed when ASU 842 took effect, requiring operating leases to be on the balance sheet. Starting Dec. 15, 2018, for public companies and Dec. 15, 2019, for private companies, right-of-use assets and liabilities resulting from leases are recorded on balance sheets.

To qualify as an operating lease under GAAP, the lease must meet specific criteria that prevent it from being classified as a capital lease. Companies must test for the four criteria, also known as the “bright line” tests, listed above that determine whether rental contracts must be booked as operating or capital leases. If none of these conditions are met, the lease can be classified as an operating lease. Otherwise, it’s likely to be a capital lease.

The Internal Revenue Service (IRS) may also reclassify an operating lease as a capital lease to reject the lease payments as a deduction, thus increasing the company’s taxable income and tax liability.

Accounting Practices for Capital Leases

A capital lease is an example of accrual accounting’s inclusion of economic events, which requires a company to calculate the present value of an obligation on its financial statements. For example, if the present value of the lease obligation is estimated at $100,000, the company records a $100,000 debit to the fixed asset account and a $100,000 credit to the capital lease liability account on its balance sheet.

Because a capital lease is financing, companies must split payments into interest and depreciation based on rates. Suppose the company makes a $1,000 monthly lease payment, with $200 allocated to interest. In this case, the company records a $1,000 credit to the cash account, a $200 debit to the interest expense account, and an $800 debit to the capital lease liability account.

A company must also depreciate the leased asset, a factor in its salvage value and useful life. For example, if the asset has a 10-year useful life and no salvage value based on the straight-line basis depreciation method, it would record a $833 monthly debit entry to the depreciation expense account and a credit entry to the accumulated depreciation account. Upon disposal of the asset, the company would credit the fixed asset account and debit the accumulated depreciation account for the remaining balances.

The Bottom Line

The fundamental concept of a capital lease is in its treatment as an asset purchase, with ownership benefits and the risks shifting to the lessee. The criteria for classifying a lease as a capital lease include ownership transfer, a bargain purchase option, a lease term relative to the asset’s useful life, or lease payments matching the asset’s market value.

Capital leases differ from operating leases in that they are treated like asset purchases, affecting interest, depreciation, and tax deductions. Investors should consult with a tax professional for personalized financial advice.