Capital Leases

Capital Leases A capital lease (also called a finance lease) transfers most of the ownership benefits and risks of an asset from the lessor to the lessee. For accounting purposes, a capital lease is treated like a purchase: the lessee records an asset and a corresponding liability on the balance sheet and recognizes interest and depreciation over the lease term. When a Lease Is Classified as a Capital (Finance) Lease A lease is classified as a capital/finance lease if it meets any of these criteria: Explore More Resources

  * Ownership transfers to the lessee at the end of the lease.
  * The lease contains a bargain purchase option (a purchase price significantly below fair value).
  * The lease term covers a major part of the asset’s economic life (commonly applied as 75% or more).
  * The present value of lease payments is substantially all of the asset’s fair value (commonly applied as 90% or more).

Accounting standards (ASC 842 / FASB guidance) require lessees to recognize most long-term leases on the balance sheet as a right-of-use (ROU) asset and a lease liability. Classification determines how expense is recognized over the term. Accounting Treatment (Lessee) Initial recognition:
* Record the ROU asset and lease liability at the present value of lease payments. Explore More Resources

Example journal entry at lease inception (PV = $100,000):
Debit: Right-of-use asset $100,000
Credit: Lease liability $100,000 Subsequent accounting:
Split each lease payment into interest expense and principal reduction of the lease liability.
Example: $1,000 payment with $200 interest → debit interest expense $200, debit lease liability $800, credit cash $1,000.
Depreciate the ROU asset over the useful life or the lease term (depending on circumstances).
Example: 10-year life, no salvage → straight-line monthly depreciation ≈ $833 ($10,000/year ÷ 12). Explore More Resources

Expense recognition:
Finance (capital) lease: separate interest expense and amortization/depreciation.
Operating lease (under ASC 842): single lease expense recognized generally on a straight-line basis (but ROU asset and liability still appear on the balance sheet). Comparison with Operating Leases
* Capital/finance lease: treated like a financed purchase—asset and liability on balance sheet; interest and depreciation on the income statement.
* Operating lease (ASC 842): ROU asset and lease liability recorded on the balance sheet, but lessee typically recognizes a single lease expense over the term.
* Historically, operating leases could be kept off-balance-sheet; modern standards require most leases >1 year to be reported on the balance sheet, improving transparency of obligations.
* Classification affects financial ratios (debt-to-equity, leverage, EBITDA) and may influence covenant compliance and borrowing capacity.
Tax Treatment
* For tax purposes, the IRS may apply different rules and can reclassify leases.
* Generally:
* Finance (capital) lease: lessee can deduct interest expense portion and depreciate the asset (subject to tax rules).
* Operating lease: lessee typically deducts the lease payments as rental expense.
* Consult a tax professional for specific tax treatment and planning.
Practical Considerations
* Review lease terms for ownership transfer, purchase options, term length relative to useful life, and payment structure—these drive classification.
* Assess financial statement and covenant impacts before entering long-term leases.
* Consider negotiating purchase options, residual guarantees, or variable-payment terms with classification implications in mind.
* Ensure systems capture present-value calculations and disclosure requirements under current lease accounting standards.
Example A company leases machinery for 10 years while the machinery’s useful life is 12 years and includes a low-price purchase option at term end. Because the term covers most of the asset’s useful life and there is a bargain purchase option, the lease would be classified as a capital/finance lease and accounted for as a financed asset purchase. Explore More Resources

Key Takeaways
* A capital lease shifts ownership-like risks and benefits to the lessee and is treated like an asset purchase for accounting.
* Classification is determined by specific criteria (ownership transfer, bargain purchase, lease term relative to useful life, present value of payments).
* Capital leases increase reported assets and liabilities and change income statement recognition (interest + depreciation).
* Newer lease accounting rules require most long-term leases to be recognized on the balance sheet, improving transparency.