Is a Capital Lease the Same as a Finance Lease?

The terms “capital lease” and “finance lease” often cause confusion, leading many to wonder if they refer to the same concept. While these terms were once distinct or used interchangeably, current accounting standards have largely converged their meaning for lessees. This article will clarify the relationship between these lease classifications by explaining the evolution of lease accounting and the current treatment of finance leases.

Evolution of Lease Accounting Standards

Historically, lease accounting in the United States was governed by Financial Accounting Standards Board (FASB) Statement No. 13 (FAS 13), later codified as Accounting Standards Codification (ASC) Topic 840. Under this standard, leases were primarily classified as either “capital leases” or “operating leases.” Capital leases reflected the economic substance of ownership, requiring balance sheet recognition if risks and rewards transferred to the lessee. Operating leases remained largely off-balance sheet, with lease payments expensed as incurred.

The landscape of lease accounting significantly changed with the implementation of ASC Topic 842, Leases, by the FASB. Effective for public companies in fiscal years beginning after December 15, 2018, and for private companies a year later, this standard aimed to increase transparency by requiring nearly all leases on the balance sheet. Under ASC 842, the term “capital lease” for lessees was replaced with “finance lease.”

For lessees, the accounting outcome for finance leases under ASC 842 is largely similar to that of capital leases under the previous FAS 13/ASC 840 guidance. Both require the recognition of an asset and a liability on the balance sheet. This terminology change also aligns with International Financial Reporting Standard (IFRS) 16, Leases, which similarly mandates balance sheet recognition for most leases.

IFRS 16, effective for annual reporting periods beginning on or after January 1, 2019, introduced a single lessee accounting model where assets and liabilities are recognized for all leases with a term exceeding 12 months, unless the underlying asset is of low value. This global convergence in standards has led to a more consistent approach to lease reporting. While the nomenclature shifted, the underlying principle of recognizing substantive ownership arrangements on the balance sheet remains central to finance leases.

Defining a Finance Lease

Under ASC 842, a lease is classified as a finance lease if it meets any one of five specific criteria at the lease commencement date. These criteria identify leases where the lessee obtains control of the underlying asset and assumes substantially all ownership risks and rewards. If none of these criteria are met, the lease is classified as an operating lease.

The first criterion is the transfer of ownership of the underlying asset to the lessee by the end of the lease term. If the lease agreement explicitly states that the title of the asset will pass to the lessee, it signifies a finance lease.

The second criterion involves a purchase option that the lessee is reasonably certain to exercise. This means the lessee has the right to purchase the asset at a price that makes it highly probable they will do so, often significantly below the expected fair value at the time the option becomes exercisable.

The third criterion considers whether the lease term covers a major part of the remaining economic life of the underlying asset. While ASC 842 does not specify a strict percentage, common practice and implementation guidance indicate that a lease term covering 75% or more of the asset’s remaining economic life often indicates a finance lease.

The fourth criterion evaluates if the present value of lease payments and any guaranteed residual value equals or exceeds substantially all of the underlying asset’s fair value. While no precise percentage is mandated, a threshold of 90% or more is frequently used.

Finally, the fifth criterion relates to the specialized nature of the underlying asset. If the asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease term, it points to a finance lease. This implies the asset was custom-made or significantly modified for the lessee, making it impractical for the lessor to lease it to another party. The presence of any single one of these five conditions results in a finance lease classification.

Accounting Treatment for Finance Leases

Once a lease is classified as a finance lease, the lessee must recognize a “Right-of-Use” (ROU) asset and a corresponding lease liability on the balance sheet at the commencement date. The initial measurement of both the ROU asset and the lease liability is based on the present value of the lease payments. This calculation uses the interest rate implicit in the lease, if determinable, or the lessee’s incremental borrowing rate.

The subsequent accounting treatment for finance leases differs from operating leases. On the income statement, the ROU asset is amortized over the shorter of the lease term or the useful life of the underlying asset, similar to depreciation. Separately, interest expense on the lease liability is recognized each period. This dual recognition typically results in a front-loaded expense pattern, with higher expenses in earlier periods.

On the statement of cash flows, payments related to a finance lease are typically split. The portion of the payment that reduces the principal balance of the lease liability is presented as a financing activity. The interest component is generally presented as an operating activity, though some flexibility exists based on accounting policies. This presentation provides users with a clearer view of the financing aspects.