What Is a Capital Lease in Accounting?

A lease generally represents an agreement where one party, the lessee, gains the right to use an asset owned by another party, the lessor, for a specified period in exchange for regular payments. Not all leases are treated the same way for accounting purposes, and their classification significantly impacts a company’s financial records. The way a lease is categorized, either as an operating lease or a capital lease, determines how it appears on a company’s financial statements.

A capital lease is treated differently from a typical rental agreement. This classification means that from an accounting perspective, the lessee is considered to have acquired most of the risks and rewards of owning the asset, even if legal ownership remains with the lessor.

Key Characteristics of a Capital Lease

A lease is classified as a capital lease if it meets any one of four specific criteria. One criterion is if the ownership of the leased asset automatically transfers to the lessee at the end of the lease term. This condition implies that the lessee will eventually own the asset outright, similar to a purchase agreement.

Another characteristic that can classify a lease as a capital lease is the presence of a bargain purchase option. This option allows the lessee to purchase the asset at a price significantly lower than its expected fair value at the time the option becomes exercisable. For instance, an option to buy an asset for $1,000 when its market value is expected to be $50,000.

The lease term itself can also be a determinant; if it is equal to 75% or more of the estimated economic life of the leased property, the lease is considered a capital lease. For example, if a piece of equipment has an expected useful life of 10 years and the lease agreement is for 7.5 years or longer, this criterion would be met.

Finally, a lease is classified as a capital lease if the present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased property. This calculation considers the time value of money, meaning future payments are discounted back to their current worth. If the sum of these discounted payments is close to or greater than the asset’s original market price, it indicates that the lessee is effectively financing the purchase of the asset over the lease term.

Accounting for Capital Leases

When a lease is identified as a capital lease, companies must record it on their balance sheet, treating it much like an asset purchase financed by a loan. At the beginning of the lease, both a Right-of-Use (ROU) asset and a corresponding lease liability are recognized. The value recorded for both is the present value of the minimum lease payments, or the fair value of the asset if lower.

The ROU asset is then depreciated over its useful life or the lease term, whichever is shorter, similar to how a purchased asset is depreciated. This depreciation expense is recorded on the income statement over the lease period. Meanwhile, the lease liability is reduced as lease payments are made, with each payment split between an interest component and a principal reduction component.

On the income statement, instead of recording a simple rent expense, a company will report both depreciation expense on the leased asset and interest expense on the lease liability. The interest expense is calculated based on the outstanding lease liability, similar to how interest on a loan is calculated. This leads to a front-loaded expense recognition, where expenses are higher in the early years of the lease due to higher interest expense.

Regarding the cash flow statement, 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, however, is categorized as an operating activity, aligning with other interest expenses. This distinction impacts the reported cash flow from different activities.

Financial Statement Implications

Classifying a lease as a capital lease impacts a company’s financial statements. On the balance sheet, both assets and liabilities increase significantly. The recognition of a Right-of-Use asset boosts total assets, while the corresponding lease liability increases total debt.

The income statement also reflects these changes, with depreciation expense on the leased asset and interest expense on the lease liability replacing a single rent expense. This accounting treatment results in higher total expenses in the early years of the lease, as interest expense is higher at the beginning of a loan’s life. Conversely, in later years, expenses may be lower compared to an operating lease as interest declines.

These accounting differences directly influence various financial ratios. For instance, debt-related ratios such as the debt-to-equity ratio and debt-to-asset ratio will appear higher due to the increased lease liability on the balance sheet. Return on assets (ROA) may also appear lower because the asset base is larger due to the capitalized lease asset. Additionally, earnings before interest, taxes, depreciation, and amortization (EBITDA) can be higher with capital leases compared to operating leases. This is because depreciation and interest expenses, which are associated with capital leases, are added back when calculating EBITDA, whereas operating lease payments (rent expense) are not.