Criteria for a capital lease
/What are the Criteria for a Capital Lease?
A capital lease is a lease in which the lessor only finances the leased asset, and all other rights of ownership transfer to the lessee . This results in the recordation of the asset as the lessee's property in its general ledger , as a fixed asset . The lessee can only record the interest portion of a capital lease payment as expense, as opposed to the amount of the entire lease payment in the case of the more common operating lease .
Note:The capital lease concept was replaced in Accounting Standards Update 2016-02 (released in 2016 and in effect as of 2019) with the concept of a finance lease . Consequently, the following discussion is for historical purposes only.
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Capital Lease Criteria
The criteria for a capital lease can be any one of the following four alternatives:
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Ownership . The ownership of the asset is shifted from the lessor to the lessee by the end of the lease period; or
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Bargain purchase option . The lessee can buy the asset from the lessor at the end of the lease term for a below-market price; or
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Lease term . The period of the lease encompasses at least 75% of the useful life of the asset (and the lease is noncancellable during that time); or
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Present value . The present value of the minimum lease payments required under the lease is at least 90% of the fair value of the asset at the inception of the lease.
Accounting for a Capital Lease and Operating Lease
If a lease agreement contains any one of the preceding four criteria, the lessee records it as a capital lease. Otherwise, the lease is recorded as an operating lease. The recordation of these two types of leases is as follows:
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Capital lease . The present value of all lease payments is considered to be the cost of the asset, which is recorded as a fixed asset, with an offsetting credit to a capital lease liability account. As each monthly lease payment is made to the lessor, the lessee records a combined reduction in the capital lease liability account and a charge to interest expense . The lessee also records a periodic depreciation charge to gradually reduce the carrying amount of the fixed asset in its accounting records .
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Operating lease . Record each lease payment as an expense. There is no other entry.
Given the precise definition of a capital lease, the parties to a lease are usually well aware of the status of their lease arrangement before a lease is signed, and typically write the lease agreement so that the arrangement will be clearly defined as either a capital lease or operating lease.
