Is a Finance Lease the Same as a Capital Lease?

Is a finance lease the same as a capital lease? While these terms are often used interchangeably, it is important to understand their relationship within accounting standards. “Capital lease” is an older designation, while “finance lease” is its modern equivalent for lessees under current accounting guidelines. This article clarifies the evolution of these terms and explains what a finance lease entails for businesses.

Understanding the Lease Accounting Evolution

Historically, under FASB Accounting Standards Codification (ASC) 840, leases were categorized as either capital leases or operating leases. A capital lease was a financing arrangement, recorded on the company’s balance sheet with an asset and a corresponding liability. Operating leases were treated as rental agreements, with payments expensed as incurred and generally kept off the balance sheet, leading to “off-balance sheet financing.”

The Financial Accounting Standards Board (FASB) introduced ASC 842, Leases, to enhance transparency in financial reporting and bring most lease obligations onto the balance sheet. This new standard replaced ASC 840 and became effective for publicly traded companies in 2018 and for private companies in 2021. A key change under ASC 842 was renaming “capital lease” to “finance lease” for lessees, though the concept of transferring significant risks and rewards of ownership to the lessee remains.

Under ASC 842, almost all leases with terms longer than 12 months now require recognition on the balance sheet, whether classified as finance or operating leases. This change ensures that financial statements provide a more complete picture of a company’s lease obligations. While both types of leases appear on the balance sheet, their accounting treatment and financial statement presentation differ significantly.

Identifying a Finance Lease

Under ASC 842, a lease is classified as a finance lease if it meets any one of five specific criteria. If none of these criteria are met, the lease is classified as an operating lease. These criteria are designed to identify leases where the lessee obtains control of the underlying asset and substantially all its economic benefits and risks, similar to outright ownership.

The first criterion is met if the lease agreement transfers ownership of the underlying asset to the lessee by the end of the lease term. The second criterion involves a purchase option that the lessee is reasonably certain to exercise. This means the lessee has the option to buy the asset at a price that makes exercising the option highly probable, such as a bargain purchase option.

The third criterion considers the lease term in relation to the asset’s economic life. A lease is a finance lease if the lease term covers a major part of the remaining economic life of the underlying asset. While ASC 842 removed the explicit 75% “bright line” rule from prior standards, many practitioners still use this percentage as a common guideline for what constitutes a “major part.”

The fourth criterion is met if the present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset. Similar to the lease term criterion, a common guideline for “substantially all” is 90% or more of the asset’s fair value.

The fifth criterion applies if the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. This implies the asset has been customized or designed specifically for the lessee’s needs, making it impractical for the lessor to lease or sell it to another party.

Financial Impact of a Finance Lease

When a lease is classified as a finance lease under ASC 842, it has distinct implications for a company’s financial statements. On the balance sheet, the lessee recognizes a Right-of-Use (ROU) asset and a corresponding lease liability at the commencement of the lease. The ROU asset represents the lessee’s right to use the underlying asset, and the lease liability reflects the present value of future lease payments.

The income statement presentation for a finance lease involves two separate expense components: amortization expense for the ROU asset and interest expense on the lease liability. The ROU asset is amortized over the shorter of the lease term or the useful life of the asset. The interest expense on the lease liability is calculated using the effective interest method, meaning it will generally be higher in the earlier years of the lease and decline over the lease term as the liability balance decreases. This results in a “front-loaded” total expense recognized in the income statement for finance leases.

On the cash flow statement, payments made for a finance lease are separated into principal and interest components. The principal portion of the lease payments is classified as a financing activity, reflecting the repayment of the lease liability. The interest portion of the payments is typically classified as an operating activity, although companies have some flexibility to classify interest payments as financing activities. This treatment differs from operating leases under ASC 842, where a single, straight-line lease expense is recognized in the income statement, and all cash payments are generally classified as operating activities. The distinct financial statement presentation of finance leases provides users with a clearer view of the financing nature of these arrangements.