What is a Capital Lease?
A Capital Lease, also known as a finance lease, is a type of lease in which the lessee records the leased asset as if they own it. Unlike an operating lease, which is treated as a rental, a capital lease has characteristics of ownership and must meet at least one of the following criteria:
- Ownership Transfer: The lease transfers ownership of the property to the lessee by the end of the lease term.
- Bargain Purchase Option: The lease includes an option for the lessee to purchase the leased asset at a bargain price.
- Lease Term: The lease term is 75% or more of the estimated economic life of the leased property.
- Present Value: The present value of the minimum lease payments equals or exceeds 90% of the fair market value of the leased property.
Examples
Example 1 - Ownership Transfer:
- A company leases a piece of manufacturing equipment for ten years, and at the end of the lease term, ownership of the equipment automatically transfers to the company. This would classify as a capital lease due to the transfer of ownership.
Example 2 - Bargain Purchase Option:
- A business leases a vehicle for eight years with an option to purchase it at the end of the lease for $1. Since the purchase price is significantly lower than the market value, it is considered a bargain purchase option, making it a capital lease.
Frequently Asked Questions (FAQs)
What is the difference between a capital lease and an operating lease?
A capital lease is treated as an asset on the lessee’s balance sheet, reflecting ownership characteristics. An operating lease, on the other hand, is treated as a rental and does not appear as an asset or liability on the balance sheet.
Can a lease be classified as an operating lease even if it meets one of the capital lease criteria?
No. If a lease meets even one of the capital lease criteria, it must be categorized as a capital lease and recorded as an asset and liability on the balance sheet.
What happens to the asset at the end of a capital lease?
Depending on the terms of the lease, the lessee may end up owning the asset (through ownership transfer or exercise of a bargain purchase option) or may have to return it.
How is the present value of lease payments calculated?
The present value of lease payments is calculated by discounting the lease payments at the rate implicit in the lease or the lessee’s incremental borrowing rate.
What financial reporting standards apply to capital leases?
In the United States, capital leases are governed by the Financial Accounting Standards Board (FASB) under the guidelines of Accounting Standards Codification (ASC) Topic 842.
Related Terms
Finance Lease
A finance lease is essentially the international term for a capital lease. It functions similarly, where the lessee recognizes both an asset and liability corresponding to the present value of lease payments.
Bargain Purchase Option
A provision in a lease contract that allows the lessee to purchase the leased asset at a price significantly below its fair market value, typically at the end of the lease term.
Present Value
The current worth of a future sum of money or stream of cash flows given a specified rate of return. In leases, it is used to assess whether the present value of the minimum lease payments meets capital lease criteria.
Online References
For further detail, consider reviewing the following online resources:
Suggested Books for Further Studies
- Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- A thorough text that covers accounting standards, including those related to leases.
- Financial Accounting by Robert Libby, Patricia Libby, and Frank Hodge
- This book offers a comprehensive foundation with current accounting practices, including detailed coverage of lease accounting.
Accounting Basics: “Capital Lease” Fundamentals Quiz
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