Capital Lease Accounting 101

 Capital lease accounting is the accounting method used to record assets acquired under a lease agreement. In a capital lease, the lessee (or the company renting the asset) is treated as if they purchased the asset using borrowed funds. Meanwhile the lessor (or the owner of the asset) acts as the financing party. It’s essential for companies to properly account for leases because it impacts a company's financial ratios, debt levels, and overall financial health. It also ensures a company is compliant with accounting standards.

In order to truly understand how capital leases are treated in accounting, you first need to understand what a capital lease is and how it differs from other types of leases.

A capital lease is a type of lease agreement where the lessee (the company or individual renting the asset) assumes the risks and rewards of ownership of the leased asset. The lessee treats the leased asset as if they purchased and financed it through the lease agreement.

Capital leases must meet at least one of the following criteria defined by Generally Accepted Accounting Principles (GAAP) in the United States:

1. The duration of the lease is equal to roughly 75% or more of the asset's useful economic life.
2. The lessee has the option to buy the asset at the end of the lease term at a bargain purchase price that is below the fair market value.
3. The lessee gains ownership at the end of the lease period.
4. The present value of lease payments must be greater than 90% of the asset’s fair market value.

If the lease meets any of the above criteria, it is classified as a capital lease.

Key characteristics of a capital lease include:

1. Ownership transfer: At the end of the lease term, the lessee has the option to purchase the asset at a predetermined price, which is often a nominal amount. This purchase option provides the lessee with a reasonably certain expectation that they will become the owner of the asset.
2. Long-term nature: Capital leases usually have a long duration that covers a significant part of the asset's useful life. In some cases, the lease term may extend to the entire economic life of the asset
3. Bargain purchase option: The lease agreement usually includes a provision for the lessee to buy the asset below its fair market value. This feature reinforces the likelihood of the lessee exercising the purchase option
4. Present value test: To qualify as a capital lease, the lease contract must meet specific accounting criteria, such as the present value of lease payments exceeding a certain threshold (usually 90%) of the asset's fair market value at the inception of the lease.

From a lease accounting perspective, a capital lease is treated as if the lessee has purchased the asset using debt financing. The asset and the associated lease liability are recorded on the lessee's balance sheet. Each lease payment is allocated between the reduction of the lease liability and interest expense.

Capital leases impact the lessee's financial statements in the following ways:

• Balance Sheet: The leased asset is recorded as a fixed asset, and a corresponding lease liability is recognized on the balance sheet.
• Income Statement: The lessee will report interest expense on the lease liability and depreciation expense on the leased asset.
• Cash Flow Statement: Lease payments are classified as a combination of both principal (reduction of lease liability) and interest payments (interest expense).

It's important for companies to distinguish between capital leases and operating leases as the accounting treatment can significantly affect a company's financial ratios and overall financial position. As accounting standards may vary between countries and regions, it's essential to consult with a qualified accountant or financial professional for specific guidance and compliance.

Yes, capital leases go on a balance sheet. When a company enters into a capital lease agreement, the leased asset and the corresponding lease liability are recorded on the lessee's balance sheet. Here are some things to keep:

• Leased Asset on the Balance Sheet: The value of the leased asset is recorded as a fixed asset on the balance sheet. The amount recorded is generally the present value of the minimum lease payments or the fair market value of the leased asset, whichever is lower.
• Lease Liability on the Balance Sheet: A lease liability is recognized on the balance sheet, representing the present value of the minimum lease payments. This liability represents the obligation of the lessee to make future lease payments to the lessor.
• Splitting Lease Payments: Each time the lessee makes a lease payment, the payment is divided into two parts: one part is treated as a reduction of the lease liability, and the other part is recognized as interest expense.
• Depreciation Expense: The leased asset is depreciated over its useful life, and the depreciation expense is recorded on the income statement.
• Interest Expense: The interest portion of each lease payment is recorded as interest expense on the income statement.

It's important to note that by recognizing both the leased asset and the lease liability on the balance sheet, capital leases can have a significant impact on a company's financial ratios and financial position.

Capital leases and finance leases are one and the same. They are, however, different from operating leases and accounting for leases remains different for finance and operating leases. Capital leases are recorded as both an asset and a liability on the lessee's balance sheet. Additionally, the lease payments are divided into principal and interest components, similar to a loan payment.

Operating lease payments, however, are treated as rental expenses and not recorded as assets or liabilities on a balance sheet. They are simply recognized as an operating expense during the period in which the asset is being leased.

There are a number of factors to consider when deciding between an operating and capital lease, including ownership risk and reward, accounting treatment, tax implications, cash flow considerations, and the nature of the leased asset. It's essential that businesses carefully evaluate the terms of the lease and its classification to ensure proper financial reporting and compliance with accounting standards. 

In contrast to capital leases, operating leases, which are treated more like rental agreements, do not result in the recognition of an asset and a liability on the lessee's balance sheet. Instead, operating lease payments are generally treated as operating expenses and have a less substantial impact on a company's financial statements.

Other major differences include:

Ownership and Risk/Reward

Capital Lease: In a capital lease, the lessee (the company leasing the asset) assumes most of the risks and rewards associated with owning the leased asset. The lease terms are structured in a way that resembles a purchase transaction, and by the end of the lease term, the lessee usually has the option to buy the asset at a predetermined price (bargain purchase option). The lessee expects to become the owner of the asset.

Operating Lease: In an operating lease, the lessor (the company owning the asset) retains most of the risks and rewards of ownership. The lessee uses the asset for a specific period but doesn't have the option to buy it at a favorable price at the end of the lease term. The lessor expects to retain ownership and either re-lease the asset or use it for other purposes after the lease term ends.

Accounting Treatment

Capital Lease: A capital lease is treated as if the lessee has purchased the asset using debt financing. Both the leased asset and the corresponding lease liability are recorded on the lessee's balance sheet. Each lease payment is allocated between the reduction of the lease liability and interest expense. Additionally, the leased asset is depreciated over its useful life, and depreciation expense is recognized on the income statement.

Operating Lease: An operating lease is treated more like a rental agreement. The leased asset is not recorded on the lessee's balance sheet, and there is no lease liability. Instead, the lease payments are typically recognized as operating expenses on the income statement as they are incurred.

Impact on Financial Ratios and Metrics

Capital Lease: Since both the asset and the liability are recorded on the balance sheet, a capital lease can increase the company's total assets and total liabilities. This can affect financial ratios such as debt-to-equity ratio, leverage ratios, and return on assets

Operating Lease: As operating lease obligations are not recorded on the balance sheet, they have less impact on the company's financial ratios and metrics. However, companies must disclose operating lease commitments in the footnotes of their financial statements.

Tax Implications

Capital Lease: The interest portion of the lease payments in a capital lease is usually tax-deductible, which can provide some tax benefits to the lessee.

Operating Lease: Lease payments in an operating lease are treated as operating expenses and are generally fully tax-deductible.

With a capital lease, the lessee must recognize the rented property as both an asset and a liability on their balance sheet. The asset represents the right to use the leased item, and the liability represents the obligation to make future lease payments. During the lease term, the lessee depreciates the leased asset and records interest expense on the lease liability.

Accounting for capital leases must adhere to the requirements defined by the Financial Accounting Standards Board (FASB). FASB has issued accounting standards related to leases, including ASC 840 and ASC 842, which govern the accounting treatment of capital leases. ASC 842 replaced ASC 840 at the end of 2018 and is now considered the standard that all U.S. businesses must adhere to.

There are a few primary differences between ASC 840 and ASC 842 accounting standards. Under ASC 840, only capital leases were recorded on the lessee's balance sheet, while operating leases were treated as off-balance sheet items and disclosed in footnotes. Lease classification was based on specific tests related to ownership transfer, bargain purchase option, lease term, and present value of lease payments.

In contrast, ASC 842 requires both operating and finance leases to be recognized on the lessee's balance sheet as "Right-of-Use" assets and corresponding lease liabilities. The new standard is more principles-based, focusing on the extent of lessee control over the underlying asset during the lease term.

ASC 842 became effective for fiscal years beginning after December 15, 2018 for public companies and later for private companies, enhancing transparency and comparability in lease reporting.

Lease management, lease accounting and capital lease accounting, in particular, are complex. And that complexity is intensified when you’re managing a large number of real estate assets. Accruent offers lease accounting software that makes it easy to ensure your organization is compliant with ASC 842. Request a demo of our lease accounting software, Lucernex, or watch the video below to see how Lucernex helped Banfield Pet Hospital streamline its lease administration and accounting.

With Lucernex, lease data management is streamlined, calculations are automated, and precise financial reports are generated, ensuring transparency and accuracy in lease accounting practices. Our top-rated software simplifies lease classification, monitors lease terms and conditions, calculates lease payments, and facilitates proper recognition of lease assets and liabilities on the balance sheet. By harnessing the power of Lucernex, businesses can enhance efficiency, reduce errors, improve financial reporting, and make more informed decisions regarding lease-related matters.