What is Capital Lease?
A Capital Lease is a lease arrangement where the lessee has ownership characteristics. Another name for this is Finance Lease. US GAAP calls it Capital Lease and IFRS calls it Finance Lease.
A lessee, or a tenant, is the party that rents an asset from another party. By contrast, a lessor is the owner of the asset that rents it to another party. Lessor is essentially the landlord.
In a lease arrangement, the lessee rents the asset from the lessor. For example, a company can rent an office from the building landlord. If you rent an apartment, then you have a lease arrangement with the apartment landlord. This is very common. Almost every large company has a lease of some kind.
In the corporate world, large businesses rent assets (i.e. office, vehicles) for many years and for large amounts of money. Sometimes, the company leasing the asset will lease it for most of the asset’s lifespan. As a result, their lease arrangements can often contain “ownership characteristics”. The company might be technically “leasing” the asset, but their arrangement with the lessor may contain characteristics that essentially makes the lessee the owner. These lease arrangements that contain ownership characteristics are known as Capital Leases. By contrast, lease arrangements that don’t have ownership characteristics are just regular leases, or Operating Leases.
Capital Lease Accounting
With a normal Operating Lease, companies don’t record the leased assets on the Balance Sheet because they don’t own it. They’ll just record a rent expense on the Income Statement and track cash payments on the Cash Flow Statement.
With a Capital Lease, companies have to record the leased assets on the Balance Sheet, as if they own it. They will include the value of the leased assets in the Assets section. On the Liabilities section, they’ll record Capital Lease of an equal value. As a result, the Balance Sheet will balance. And then on the Income Statement, they’ll record Depreciation Expense. On the Cash Flow Statement, they’ll add back D&A and track cash payments for the rent.
It’s important to emphasize that under a Capital Lease, companies are still renting the assets. They don’t legally own the assets. The distinction of Capital vs. Operating lease is merely one of whether the arrangement has ownership characteristics. The implication of Capital versus Operating Lease is just how companies present their numbers on the financial statements.
Capital Lease Criteria
Under the US GAAP, a company must capitalize the lease if the arrangement meets any of the following criteria.
Lease Term Test
The term of the lease is greater than 75% of the asset’s estimated economic life.
Purchase Option Test
The lease includes an option to purchase the asset for less than fair market value.
Ownership Test
The lessor transfers ownership of the asset to the lessee at the end of the lease term.
Present Value Test
The present value of the lease payments exceed 90% of the asset’s fair market value.
The above is the tests that US companies have to hold themselves to under US accounting standards. Internationally, European companies following IFRS face similar tests. Under IFRS, a company should capitalize the lease if the arrangement meets any of the following criteria.
Lease Term Test
The lease term is for the major part of the economic life of the asset, even if title is not transferred.
Purchase Option Test
The lessee has the option to purchase the asset at a price sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised.
Ownership Test
The lease transfers ownership of the asset to the lessee by the end of the lease term.
Present Value Test
At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.
Specialization Test
The leased assets are of a specialized nature such that only the lessee can use them without major modifications being made.