What is a capital lease (finance lease)?
– Definition: A capital lease — also called a finance lease — is a lease arrangement that effectively transfers the economic benefits and the majority of the risks of owning an asset from the lessor (owner) to the lessee (user). When a lease meets specified tests, accounting rules require the lessee to treat the contract as if it purchased the asset.
Key concepts and short definitions
– Lessee: the party using the asset and making lease payments.
– Lessor: the party that owns the asset and receives lease payments.
– Right-of-use (ROU) asset: the lessee’s recognized asset representing the right to use the leased property.
– Lease liability: the present value (PV) of future lease payments recorded as a liability.
– Bargain purchase option: a contractual option allowing the lessee to buy the asset at a price well below expected fair value at the end of the lease term.
– Present value: the current value of future payments discounted at the appropriate interest rate.
Why classification matters
– If a lease qualifies as a capital (finance) lease, the lessee must put both an asset (ROU/fixed asset) and a matching liability on the balance sheet. That brings interest expense and depreciation onto the income statement and increases reported assets and liabilities.
– Operating leases historically could be kept off the balance sheet, understating leverage. Accounting updates (see below) changed how most leases are reported.
Four bright‑line tests (common criteria) used to determine capital-lease status
A lease is normally accounted for as a capital (finance) lease if any one of these conditions is met:
1. Ownership transfer: The lease transfers ownership of the asset to the lessee by the end of the lease term.
2. Bargain purchase option: The contract gives the lessee an option to buy the asset for a price expected to be significantly below fair market value.
3. Lease term test: The lease term covers a large portion of the asset’s useful life (commonly assessed at 75% or more).
4. Present value test: The present value of minimum lease payments is substantially all of the asset’s fair value (commonly tested at 90% or more).
Recent U.S. GAAP changes (high level)
– ASU 2016-02 (Topic 842): Lessees must recognize essentially all leases with terms longer than one year on the balance sheet as ROU assets and lease liabilities. Effective dates: public companies from Dec 15, 2018; private companies from Dec 15, 2019.
– Subsequent FASB updates (including 2021 guidance) refined lessor classifications and certain variable-payment situations. These updates tighten how leases affect reported assets, liabilities, and income.
Basic accounting treatment for a capital lease (lessee perspective)
1. Initial recognition: record an ROU asset and a lease liability equal to the present value of lease payments (or another appropriate measurement per guidance).
2. Subsequent accounting: allocate each payment between interest expense and reduction of the lease liability; depreci
ation expense on the ROU asset (usually on a straight‑line basis unless another systematic method is more appropriate).
3. Derecognition or termination: when the lease ends or is terminated, remove the related ROU asset and lease liability; recognize any gain or loss if final cash flows or asset disposition differ from the carrying amounts.
4. Presentation and disclosures: report the ROU asset and lease liability on the balance sheet. For finance (capital) leases, present interest expense and amortization (depreciation) separately in the income statement. Disclose maturity analyses, significant assumptions (discount rate, lease term), and qualitative lease terms.
Checklist — lessee steps under ASC 842 (practical)
– Identify whether a contract contains a lease (right to control identified asset for a period in exchange for consideration).
– Determine the lease term, including options only if exercise is reasonably certain.
– Identify lease payments (fixed payments, certain variable payments, residual guarantees, purchase options reasonably certain, and penalties for termination).
– Select discount rate: rate implicit in lease (if determinable) or incremental borrowing rate.
– Measure initial lease liability = present value (PV) of lease payments; measure ROU asset = lease liability adjusted for prepaid/ accrued payments, initial direct costs, and incentives.
– Classify lease as finance (capital) or operating using ASC 842 criteria (transfer of ownership, purchase option reasonably certain, lease term major part of asset’s economic life, PV of payments substantially all of asset’s fair value, or asset is specialized).
– Record subsequent accounting: amortize ROU and allocate payments between interest and principal for finance leases; for operating leases recognize single lease expense on a generally straight‑line basis.
– Maintain disclosure supporting amounts and judgments.
Worked numeric example (lessee finance/ capital lease)
Assumptions:
– Lease term: 5 years
– Annual payment: $10,000, paid at year‑end
– Discount rate (implicit or incremental): 6%
– No transfer of ownership and no purchase option (so amortize over lease term)
Step A — compute PV of payments (initial lease liability and ROU asset)
PV = payment × [1 − (1 + r)^(−n)] / r
PV = 10,000 × [1 − (1.06)^(−5)] / 0.06
PV ≈ 10,000 × 4.21236 = $42,123.60 ≈ $42,124
Initial journal entry (at lease commencement)
Dr Right‑of‑use asset