A capital lease is a contract allowing a renter to use an asset temporarily. This lease shares the same economic characteristics of asset ownership in accounting, as the lease requires book assets and liabilities to cover the lease should the lease contract meet specific criteria.
A lessee must use the capital lease accounting method in their new lease accounting journal entries and subsequent records if the rent contract entered into satisfies any of the four criteria set by the Financial Accounting Standards Board (FASB). Here are the basics of the capital lease accounting method.
What is a Capital Lease?
A capital lease or finance lease is a contract between the business acting as the lessee, and the lessor. The two parties agree that the lessor’s property will be rented out by the business in exchange for periodic rental payments. The business can never claim ownership of the asset and is required to return the said asset to the lessor after the rental period is over.
Under the capital lease accounting, the lessor transfers the rights and risks of owning a rental asset to the business renting the property. Thus, the asset is treated like it has been bought and paid for by a loan. The asset will then be depreciated over the rental period.
What is the Difference Between an Operating Lease and Capital Lease?
An operating lease differs from a capital lease because each follows a different accounting treatment and structure. An operating lease is a contract allowing the renter to use an asset but it does not offer any ownership rights to the lessee.
Operating lease accounting is a one-off recording in the balance sheets. This means that a rented asset and related liabilities of future payments are excluded from the company’s balance sheet so that the ratio of debt to equity is kept low. Traditionally, operating leases helped American companies keep billions of assets and liabilities from being included in their balance sheets.
A lease must meet specific requirements of the generally accepted accounting practices or GAAP to be recorded as an operating lease and exempted from being classified as a capital lease. Firms must assess their contracts using the “bright line” test to determine whether their rental contracts should be booked as operating or capital leases.
What are the 4 Criteria for a Capital Lease under ASC 840?
According to ASC 840, there are four tests to determine whether a lease is an operating lease or capital lease. An assessment must be conducted upon signing of the rental contract. Below are the four tests:
- Will the ownership or title of the asset be transferred to the renter when the lease term ends?
- Is a bargain purchase option available?
- Is the lease life equal to or greater than 75 percent of the remaining asset’s economic life?
- Is the present value or PV of the lease payments equal to or greater than 90 percent of the asset’s fair market value?
A lease is classified as an operating lease if none of the above conditions are met. Otherwise, it can be classified as a capital lease. In some cases, the Internal Revenue Service has reclassified an operating lease as a capital lease, which has resulted in an increase in a firm’s tax liability and taxable income.
What is the Difference Between a Capital Lease vs Finance Lease?
A capital lease, according to the ASC 842, is now referred to as a finance lease. This is because a large number of rental contracts are now capitalized except for those with a lease term of 12 months or less. The nomenclature capital lease is no longer appropriate, which is why the correct term to use is the finance lease.
Below is an excerpt from ASC 842, defining what a lease is:
Under the lessee accounting model in previous GAAP, the critical determination was whether a lease was a capital lease or an operating lease because lease assets and lease liabilities were recognized only for capital leases. Under Topic 842, the critical determination is whether a contract is or contains a lease because lessees are required to recognize lease assets and lease liabilities for all leases— finance and operating—other than short-term leases (that is, if the entity elects the short-term lease recognition and measurement exemption).
How is a Capital Lease Recorded on the Balance Sheet?
Given the capital lease’s nature of being a financing arrangement, businesses must break down the periodic rental payments into interest expense according to the firm’s applicable depreciation expense and interest rate.
For example, should the company make $1000 in monthly rental payments with an estimated interest of $200, then the following should be entered in the balance sheets:
$1000 credit to the cash account
$200 debit to the interest account
$800 debit to the capital lease liability account
It is important for businesses to depreciate the leased asset to factor in the useful life and salvage value of the asset. In our example, let us assume that the asset still has a useful life of 10 years and zero salvage value using the straight-line basis depreciation treatment. The firm has to record an $833 debit entry to the depreciation expense account monthly and a credit recorded to the accumulated depreciation account. Once the leased asset has been disposed of, then the fixed asset must be credited while the accumulated depreciation account should be debited to reflect the remaining balances.
How Does the Transition to ASC 842 Affect Businesses?
There are changes in lease accounting with the transition from ASC 840 to ASC 842. For example, there is another criterion in determining whether the leased asset should be treated as a capital lease or operating lease. It then becomes imperative for businesses to select an accounting software with features reflecting these changes in the GAAP such as our software at Visual Lease.