FAS 13 Lease Accounting: Capital vs. Operating Leases

Statement of Financial Accounting Standards No. 13, or FAS 13, was issued by the Financial Accounting Standards Board (FASB) in 1976. Its objective was to standardize how companies reported lease agreements on their financial statements. The guidance was a response to “off-balance-sheet financing,” where lease obligations were not on a company’s balance sheet, potentially obscuring its true financial position. FAS 13 established criteria to determine when a lease was economically similar to a purchase and should be accounted for accordingly.

Lease Classification Criteria

Under FAS 13, every lease was classified at its inception as either a capital lease or an operating lease. This classification was determined by a series of four tests. If a lease agreement met just one of these criteria, it was classified as a capital lease, signifying that the transaction was, in substance, a purchase of an asset. This distinction dictated the entire accounting treatment for the lease.

The four criteria for a capital lease were:

• The lease transfers legal ownership of the property to the lessee by the end of the lease term.
• The lease contains a bargain purchase option, allowing the lessee to buy the asset for a price significantly below its expected fair market value.
• The lease term is equal to 75% or more of the asset’s estimated economic life.
• The present value of the minimum lease payments equals or exceeds 90% of the leased property’s fair value at the start of the lease.

Accounting Treatment for Lessees

The classification of a lease under FAS 13 determined how a lessee reported the transaction, leading to significant variations in reported assets, liabilities, and expenses. For an operating lease, the accounting was simple. The lessee treated lease payments as a rental expense on the income statement and recorded no asset or liability on the balance sheet, which helped keep debt-to-equity ratios lower.

A capital lease required on-balance-sheet recognition. The lessee had to record an asset and a corresponding liability equal to the present value of the future minimum lease payments. This amount could not exceed the fair value of the asset at the lease’s inception. The lessee would then depreciate the capitalized asset, and each lease payment was allocated between a reduction of the lease liability and an interest expense.

Accounting Treatment for Lessors

From the lessor’s perspective, the accounting also hinged on the lease classification. If a lease did not meet any of the capital lease criteria, it was an operating lease. In this scenario, the lessor kept the asset on its balance sheet, continued to depreciate it, and recognized lease payments as rental income.

When a lease was classified as a capital lease, the lessor’s accounting depended on whether it was a sales-type or a direct financing lease. For both types, the lessor removed the leased asset from its books and recorded a net investment in the lease, which is a receivable. A sales-type lease, common for manufacturers or dealers, generated both a profit on the sale and interest income over the lease term.

A direct financing lease did not involve a manufacturer’s or dealer’s profit. In this arrangement, the lessor, often a financial institution, purchased an asset and leased it to a customer. The lessor’s income was derived solely from interest earned over the lease term.

Supersession by Current Standards

The rules established by FAS 13 are no longer the active standard. The FASB issued Accounting Standards Codification (ASC) Topic 842, Leases, which replaced the legacy guidance. This new standard became effective for public companies for fiscal years beginning after December 15, 2018, and for private companies for fiscal years beginning after December 15, 2021.

The most significant change introduced by ASC 842 was the elimination of off-balance-sheet accounting for most operating leases. Under the new rules, companies must recognize a “right-of-use” asset and a corresponding lease liability for virtually all leases with terms longer than 12 months. While the income statement treatment is similar, the new standard retains a dual-classification model for lessees, distinguishing between “finance leases” (similar to capital leases) and “operating leases.” The requirement to capitalize all long-term leases brings previously disclosed obligations onto corporate balance sheets.