What Is a Capital Lease and How Is It Accounted For?

Leases allow companies to use assets like equipment, vehicles, or property without purchasing them. These agreements involve a lessor, who owns the asset, and a lessee, who pays to use it for a specified period. Lease classification for accounting purposes has significant financial implications, affecting how a company’s financial health is presented.

Understanding Lease Classifications

Leases are categorized into two main types: capital and operating. A capital lease is treated as if the lessee has purchased and financed the asset, reflecting a transfer of economic risks and rewards of ownership. For accounting purposes, the lessee is considered the owner, even if legal title remains with the lessor.

In contrast, an operating lease is viewed more like a traditional rental agreement, where the lessor retains most of the risks and rewards of ownership. This distinction determines whether the leased asset and corresponding obligations appear on a company’s balance sheet, influencing financial metrics and reporting transparency.

Criteria for Capital Lease Classification

For a lease to be classified as a capital lease under ASC 840, it must meet at least one of four specific criteria. These criteria provide clear thresholds for classification. Note that ASC 840 was the previous standard; while the term “capital lease” is still used, newer standards (ASC 842) have shifted terminology to “finance lease” and changed some specifics, though the underlying concepts for classification remain similar.

One criterion is the transfer of ownership to the lessee by the end of the lease term. If the lease agreement explicitly states that the lessee will gain legal title to the asset when the lease concludes, it is classified as a capital lease. Another condition is the presence of a bargain purchase option. This allows the lessee to buy the asset at the end of the lease period for a price significantly lower than its expected fair market value, making it highly probable the option will be exercised.

A third criterion is the lease term being equal to or greater than 75% of the asset’s estimated useful economic life. This threshold suggests that the lessee will benefit from the asset for most of its functional existence. Finally, the present value of the minimum lease payments can trigger capital lease classification. If the present value of these payments amounts to 90% or more of the asset’s fair market value, the lease is considered a capital lease, as it effectively covers nearly the entire value of the asset.

Accounting for Capital Leases

Once a lease is determined to be a capital lease, its accounting treatment mirrors that of an asset purchase financed by debt. At the inception of the lease, the lessee recognizes both a leased asset and a corresponding lease liability on their balance sheet. The value recorded for both is the present value of the minimum lease payments, limited by the asset’s fair market value.

The leased asset is depreciated over its useful life or the lease term, whichever is shorter, with depreciation expense recognized on the income statement. Each lease payment is bifurcated into two components: a reduction of the lease liability and an interest expense. This interest expense is also recognized on the income statement, reflecting the financing cost. This treatment differs from how operating leases were historically accounted for under ASC 840, where they were treated as off-balance sheet items with only rent expense recognized.

Impact on Financial Reporting

The classification of a lease as capital has a significant impact on a company’s financial statements and key financial ratios. On the balance sheet, capital leases result in both an increase in assets, specifically a “right-of-use” asset, and a corresponding increase in liabilities, representing the lease obligation.

On the income statement, capital leases lead to the recognition of both depreciation expense on the leased asset and interest expense on the lease liability. The cash flow statement is also affected, as capital lease payments are split between financing activities (for the principal portion) and operating activities (for the interest portion). These distinctions can influence financial ratios, such as debt-to-equity ratios and return on assets, potentially affecting a company’s perceived financial health and borrowing capacity.