A capital lease, which is also known as a finance lease, is an agreement that lets a lessee use an asset while shifting most of the ownership benefits and risks from the lessor to the lessee. In contrast, an operating lease provides access to an asset but doesn’t grant ownership rights and is treated differently in accounting.
For a lease to be classified as a capital lease, it needs to meet at least one of several criteria. These include transferring ownership at the end of the lease, offering a bargain purchase option for the asset, having a lease term that covers most of the asset’s economic life, and having lease payments that closely match the asset’s fair value. If any of these conditions are satisfied, the lessee has to account for the lease as if they own the asset.
The Financial Accounting Standards Board (FASB) updated accounting procedures related to capital leases and their impact on financial statements in 2016 and 2021.
How to Account for a Capital Lease in Financial Statements
A capital lease means that the lessee has to show the leased asset and the related liability on their balance sheet if the lease fits certain criteria. Basically, a capital lease is seen as buying an asset according to generally accepted accounting principles (GAAP), whereas an operating lease is viewed as a straightforward rental contract. Capital leases influence a company’s financial statements, impacting interest expenses, depreciation expenses, assets, and liabilities.
The Example of Capital Lease
A business could rent equipment, such as machinery, under conditions that meet the criteria for a capital lease. For instance, if the business leases machinery for 10 years, which covers most of the equipment’s 12-year lifespan, and has the choice to purchase it at a low price once the lease ends, this would be classified as a capital lease.
For a lease to be considered a capital lease, it needs to meet at least one of these four criteria:
- The lease duration is at least 75% of the asset’s useful life.
- The lease includes a bargain purchase option, which lets the lessee buy the asset for a price lower than its fair market value.
- The lessee is required to take ownership once the lease period ends.
- The present value of the lease payments has to exceed 90% of the asset’s market value.
Back in 2016, the Financial Accounting Standards Board (FASB) updated the rules so that companies have to list leases longer than a year on their financial statements. This change kicked in on Dec. 15, 2018, for public companies and a year later on Dec. 15, 2019, for private ones. The reason behind this shift was that companies were using operating leases off the balance sheet, which made their actual debt levels look lower than they were.
Then in 2021, the FASB rolled out an update that required lessors to label certain leases with variable payments as operating leases if they would normally be seen as sales-type or direct financing leases and would lead to a selling loss at the beginning. Starting December 15, 2021, these updates fine-tune lease accounting standards and affect how companies handle their lease-related finances.
Conclusion
The basic idea behind a capital lease is that it’s seen as buying an asset, where the benefits and risks of ownership go to the lessee. To classify a lease as a capital lease, it must meet certain criteria: ownership transfer, a bargain purchase option, a lease term that relates to the asset’s useful life, or lease payments that align with the asset’s market value.
Unlike operating leases, capital leases are treated like asset purchases, which impacts interest, depreciation, and tax deductions. It’s a good idea for investors to talk to a tax professional for tailored financial advice.