What is a Capital Lease?
A Capital Lease, also known as a finance lease, is a type of lease in which the lessee records the leased asset as if they own it. Unlike an operating lease, which is treated as a rental, a capital lease has characteristics of ownership and must meet at least one of the following criteria:
- Ownership Transfer: The lease transfers ownership of the property to the lessee by the end of the lease term.
- Bargain Purchase Option: The lease includes an option for the lessee to purchase the leased asset at a bargain price.
- Lease Term: The lease term is 75% or more of the estimated economic life of the leased property.
- Present Value: The present value of the minimum lease payments equals or exceeds 90% of the fair market value of the leased property.
Examples
-
Example 1 - Ownership Transfer:
- A company leases a piece of manufacturing equipment for ten years, and at the end of the lease term, ownership of the equipment automatically transfers to the company. This would classify as a capital lease due to the transfer of ownership.
-
Example 2 - Bargain Purchase Option:
- A business leases a vehicle for eight years with an option to purchase it at the end of the lease for $1. Since the purchase price is significantly lower than the market value, it is considered a bargain purchase option, making it a capital lease.
Frequently Asked Questions (FAQs)
What is the difference between a capital lease and an operating lease?
A capital lease is treated as an asset on the lessee’s balance sheet, reflecting ownership characteristics. An operating lease, on the other hand, is treated as a rental and does not appear as an asset or liability on the balance sheet.
Can a lease be classified as an operating lease even if it meets one of the capital lease criteria?
No. If a lease meets even one of the capital lease criteria, it must be categorized as a capital lease and recorded as an asset and liability on the balance sheet.
What happens to the asset at the end of a capital lease?
Depending on the terms of the lease, the lessee may end up owning the asset (through ownership transfer or exercise of a bargain purchase option) or may have to return it.
How is the present value of lease payments calculated?
The present value of lease payments is calculated by discounting the lease payments at the rate implicit in the lease or the lessee’s incremental borrowing rate.
What financial reporting standards apply to capital leases?
In the United States, capital leases are governed by the Financial Accounting Standards Board (FASB) under the guidelines of Accounting Standards Codification (ASC) Topic 842.
Finance Lease
A finance lease is essentially the international term for a capital lease. It functions similarly, where the lessee recognizes both an asset and liability corresponding to the present value of lease payments.
Bargain Purchase Option
A provision in a lease contract that allows the lessee to purchase the leased asset at a price significantly below its fair market value, typically at the end of the lease term.
Present Value
The current worth of a future sum of money or stream of cash flows given a specified rate of return. In leases, it is used to assess whether the present value of the minimum lease payments meets capital lease criteria.
Online References
For further detail, consider reviewing the following online resources:
Suggested Books for Further Studies
- Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- A thorough text that covers accounting standards, including those related to leases.
- Financial Accounting by Robert Libby, Patricia Libby, and Frank Hodge
- This book offers a comprehensive foundation with current accounting practices, including detailed coverage of lease accounting.
Accounting Basics: “Capital Lease” Fundamentals Quiz
### What key feature distinguishes a capital lease from an operating lease regarding financial reporting?
- [x] Asset and liability recognition on the lessee's balance sheet.
- [ ] Only noted in the lease disclosure notes.
- [ ] Treated as a short-term rental.
- [ ] Classified as an off-balance-sheet-only transaction.
> **Explanation:** A capital lease must be recognized as an asset and liability on the lessee's balance sheet, unlike an operating lease.
### Which of the following is a condition that classifies a lease as a capital lease?
- [ ] Lease payments are variable.
- [ ] The property has high residual value.
- [x] The lease term is 75% or more of the property's economic life.
- [ ] The lease allows for the return of the asset any time during the lease term.
> **Explanation:** If the lease term covers 75% or more of the property's estimated economic life, it is classified as a capital lease.
### What does the term 'bargain purchase option' refer to in the context of a capital lease?
- [x] Option to purchase the asset at a price significantly below market value.
- [ ] Option to extend the lease term at regular payment rates.
- [ ] Option to transfer the lease to another lessee.
- [ ] Option to trade in the leased asset for another model.
> **Explanation:** A 'bargain purchase option' allows the lessee to buy the leased asset at a price considerably lower than its fair market value at the end of the lease term.
### How is the present value of lease payments assessed in determining lease classification?
- [x] By discounting future lease payments at the implicit rate or lessee's borrowing rate.
- [ ] By evaluating the lessee’s annual revenue.
- [ ] Via market appreciation forecast of the leased asset.
- [ ] Using straight-line depreciation methods.
> **Explanation:** Present value is calculated by discounting the future lease payments either at the rate implicit in the lease or the lessee's incremental borrowing rate.
### Which standard governs the recognition of Capital Leases in US GAAP?
- [ ] IFRS 16
- [ ] SOX Section 404
- [x] ASC Topic 842
- [ ] SEC Regulation M
> **Explanation:** ASC Topic 842 governs the recognition of leases, including capital leases, per the Financial Accounting Standards Board (FASB).
### What happens to an asset if the lease transfers ownership to the lessee at the end of the lease term?
- [ ] The asset is returned to the lessor.
- [ ] The asset is revalued at current market rate.
- [x] It becomes property of the lessee.
- [ ] The asset is depreciated to zero value.
> **Explanation:** If the lease transfers ownership at the end of the term, the asset becomes the property of the lessee.
### Which term best describes a discount rate used to calculate the present value of lease payments?
- [x] Implicit rate.
- [ ] Annualized rate.
- [ ] Prime rate.
- [ ] Fixed rate.
> **Explanation:** The implicit rate in the lease is used often as the discount rate to determine the present value of lease payments.
### In a capital lease, why are leased assets and liabilities reported on the balance sheet?
- [ ] To minimize taxable income.
- [ ] To hunt for better credit terms.
- [x] Because they meet specific asset recognition criteria.
- [ ] To inflate financial status.
> **Explanation:** Capital leases meet specific asset and liability recognition criteria, making their reporting on the balance sheet necessary under GAAP.
### How might lease terms impact the classification as a capital lease if it contains a renewal option?
- [x] If the renewal option payments are insignificant, it supports capital lease classification.
- [ ] Renewal options remove asset from balance sheet.
- [ ] Prevents recognition of lease asset.
- [ ] Does not affect capital lease determination.
> **Explanation:** If the lease includes a bargain renewal option with insignificant payments, it leans towards the capital lease classification.
### For a lease to qualify as a capital lease due to the present value of lease payments, what threshold must be met?
- [ ] 50% of the market value of the leased asset.
- [ ] The lease payments must be fixed.
- [x] 90% or more of the leased asset's fair value.
- [ ] Ensuring the lease payments match the rate of inflation.
> **Explanation:** To qualify as a capital lease on this basis, the present value of the minimum lease payments must equal or exceed 90% of the fair value of the leased asset.
Thank you for taking this in-depth virtual study on Capital Leases and challenging yourself with our expertly crafted quiz questions. Seize the opportunity to enrich and sharpen your financial acumen!
