Are Capital Leases and Finance Leases the Same?

Leasing assets offers businesses a flexible alternative to outright purchasing, providing access to necessary equipment, property, or vehicles without immediate financial outlay. Understanding lease accounting standards is important for accurate financial reporting, as lease classification determines how it is presented on financial statements, affecting a company’s reported assets, liabilities, and expenses.

Understanding Capital Leases Under Prior Standards

Under prior U.S. Generally Accepted Accounting Principles (US GAAP), specifically ASC 840, a “capital lease” was recognized as an arrangement that effectively transferred the risks and rewards of asset ownership from the lessor to the lessee. This classification was determined by meeting any one of four specific criteria at the lease’s inception. A lease was considered a capital lease if ownership of the asset transferred to the lessee by the end of the lease term.

Another criterion involved a bargain purchase option, which allowed the lessee to buy the asset at a price significantly lower than its expected fair value. Additionally, if the lease term covered 75% or more of the asset’s economic life, it would qualify as a capital lease. Lastly, a lease was classified as capital if the present value of the minimum lease payments amounted to 90% or more of the asset’s fair value. When any of these conditions were met, the lease was treated on the balance sheet similarly to a purchased asset.

Understanding Finance Leases Under Current Standards

Under current US GAAP, specifically ASC 842, the term “finance lease” replaced what was previously known as a capital lease. This standard brought significant changes to lease accounting, primarily requiring nearly all leases to be recognized on the balance sheet. A lease is classified as a finance lease under ASC 842 if it meets any of five criteria, which are conceptually similar to the former capital lease tests but with some nuanced differences.

The criteria include if ownership of the asset transfers to the lessee by the end of the lease term, or if the lease grants the lessee a purchase option that they are reasonably certain to exercise. A lease also qualifies as a finance lease if the lease term represents a major part of the asset’s economic life. Furthermore, if the present value of the lease payments constitutes substantially all of the fair value of the asset, it is a finance lease. The final criterion is if the asset is of such a specialized nature that it has no alternative use to the lessor after the lease term ends.

The Relationship Between Capital Leases and Finance Leases

The question of whether capital leases and finance leases are the same depends on the accounting standard referenced. For US GAAP, the term “capital lease” used under the older ASC 840 standard was superseded by “finance lease” under the newer ASC 842 standard. Therefore, these terms refer to the same fundamental classification of a lease, but they exist under different accounting frameworks. The change in nomenclature was part of a broader effort to enhance transparency in financial reporting and align US GAAP closely with International Financial Reporting Standards (IFRS), which has historically used the term “finance lease.”

While the name changed and some specific thresholds were adjusted, the underlying concept of these leases remains consistent. Both capital leases and finance leases represent arrangements where the lessee gains substantially all the risks and rewards of owning the asset, even without legal title. For example, the criteria regarding the transfer of ownership and the present value of lease payments covering most of the asset’s fair value are present in both standards. The transition from ASC 840 to ASC 842 primarily aimed to ensure that more lease obligations are reflected on a company’s balance sheet, providing a more complete picture of its financial position.

Financial Reporting Implications

The classification of a lease as a finance lease (or capital lease) has a significant impact on a company’s financial statements. For finance leases, companies must recognize a “Right-of-Use” (ROU) asset and a corresponding lease liability on their balance sheet. This means that the asset and the obligation to make lease payments are both clearly presented, reflecting the economic substance of the transaction.

On the income statement, finance leases result in the recognition of both depreciation expense on the ROU asset and interest expense on the lease liability. This differs from operating leases, where typically a single, straight-line lease expense is recognized over the lease term. The distinct financial reporting treatment for finance leases provides users of financial statements with a clearer view of a company’s long-term commitments and asset utilization.