What is a Capital Lease?
A capital lease is a game-changing contract granting a renter the temporary use of an asset with all the economic benefits of ownership for accounting purposes.
Key Takeaways
- A capital lease permits the lessee temporary use but with ownership-like economic characteristics.
- For accounting, it’s considered an asset purchase, unlike an operating lease treated as a true lease under generally accepted accounting principles (GAAP).
- In accounting, a capital leased asset appears on the lessee’s balance sheet as though actually owned.
- By contrast, an operating lease does not confer ownership-like rights and is accounted differently.
Dive Deep into Capital Lease
A capital lease requires renters to book assets and liabilities tied to the lease if specific terms are met. Essentially, it is viewed as an asset purchase for accounting purposes, as per GAAP standards, unlike an operating lease. Companies’ financial statements, revealing assets, liabilities, depreciation, and interest expenses, are significantly influenced by capital leases.
To qualify as a capital lease, any of the following four criteria must be satisfied:
- Lease life is 75% or greater of the asset’s useful life.
- It includes a bargain purchase option for less than market value.
- Ownership transfers to the lessee by lease-end.
- Present value of lease payments exceeds 90% of the asset’s market value.
Whether a lease is capitalized affects how it’s recorded, significantly influencing financial metrics and business tax strategies.
Capital Leases Vs. Operating Leases: A Time for Choice
An operating lease, different in structure and accounting from a capital lease, permits use of an asset without ownership rights. Historically, companies could keep extensive assets off-balance through operating leases. This changed with the enactment of ASU 842, which mandates the recording of right-of-use assets and liabilities on balance sheets.
Classification depends on testing for specific GAAP conditions. Failure to meet any can grant a lease the status of an operating lease; else, it becomes a capital lease with resultant accounting treatments.
Accounting for Capital Leases: Detailed Walkthrough
Capital leases are an example of accrual accounting capturing economic events, obliging companies to list the present value of obligations. For about $100,000 present value obligation, entries are made in expense and income accounts. Depending on agreed periodic payments, diverse components like interest and depreciation are systematically recorded. For example, a $1,000 monthly lease payment is split into interest and liability entries depending on specific company interest rates.
Moreover, leased assets undergo depreciation considering factors like salvage value and useful life. Straight-line basis depreciation disperses expense entries consistent with asset longevity.
Related Terms: Operating Lease, Accrual Accounting, Present Value, Depreciation Expense.
References
- Financial Accounting Standards Board. “FASB Accounting Standards Update No. 2016-02 Leases (Topic 842)”, Page 87.
- Financial Accounting Standards Board. “Proposed Accounting Standards Update 840-10-25-43”.
- Internal Revenue Service. “Publication 535: Business Expenses”, Page 11.
