Definition
Capital Lease Criteria are standards set by Financial Accounting Standards Board (FASB) to determine whether a lease is a capital lease or an operating lease. This determination is crucial because it affects how the lease is recorded in the company’s financial statements. The criteria typically include conditions like lease term is 75% or more of the asset’s life, the present value of lease payments is 90% or more of the fair market value of the asset, ownership of the asset being transferred to lessee at the end of the lease term, or the lease containing a bargain purchase option.
Key Takeaways
- Under the umbrella of finance, Capital Lease Criteria is a set of conditions a leasing agreement meets to be considered a capital lease. This type of lease primarily signifies that risks and rewards associated with the ownership of the asset are transferred to the lessee throughout the lease term.
- The four main requirements for a lease to qualify as a capital lease as per the U.S. GAAP are: the lease tenure is 75% or more of the leased asset’s useful life, the present value of lease payments is at least 90% of the asset’s fair market value, there is a transfer of ownership to the lessee at the end of the lease, and the lease agreement includes a bargain purchase option.
- Accounting for capital leases differs significantly from operating leases. In case of a capital lease, the asset and liability are both recognized in the lessee’s balance sheet. On the other hand, for operating leases, only the lease expense is recognized in the income statement of the lessee.
Importance
Capital Lease Criteria is crucial to properly categorize and account for leases in finance.
This is because the nature of a lease, whether it’s an operating lease or a capital lease, can significantly impact a company’s balance sheet, income statement, and cash flow statement.
The criteria for a capital lease, which typically allows the lessee to act as the de facto owner of the leased asset, includes long-term lease periods, transfer of ownership at the end of the lease, a bargain purchase option, and high present value of lease payments.
These factors all ensure assets and liabilities are accurately represented on the company’s financial statements, thereby allowing a clearer view on a firm’s financial health.
Thus, understanding and applying the capital lease criteria is critical for accurate financial reporting and decision-making.
Explanation
The purpose of Capital Lease Criteria is to help both lessees and lessors make the distinction between capital and operational leases. This is essential because the type of lease has significant effects on both the financial statements and the tax situations of the parties involved.
A capital lease, also recognized as a finance lease, is essentially treated like an asset on the lessee’s balance sheet. By utilizing the capital lease criteria, entities are able to decide whether to record an asset and obligation to pay for the asset, which affects their financial metrics, such as debt ratio, profitability ratio, and more.
The capital lease is used for long-term leasing and allows for the lessee to eventually acquire the asset. Therefore the Capital Lease Criteria are used to determine if the lease transfers the ownership of the property to the lessee by the end of the lease term, if the lease contains a bargain purchase option, if the lease term is 75% or more of the economic life of the leased property, or if the present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased property.
In essence, with these criteria, entities can ensure that their lease agreements align with their financial objectives and correctly reflect their financial situation.
Examples of Capital Lease Criteria
Company Vehicles: A corporation might decide to lease a fleet of cars for its employees. If the lease agreement meets the capital lease criteria – such as the lease term is for 75% or more of the life of the car, the lease agreement includes a transfer of ownership at the end, or there is some form of ‘bargain purchase option’ – then it would be considered a capital lease. Even though the corporation does not technically own the cars, they would have to record the cars as assets and the lease payments as liabilities on their balance sheet.
Industrial Equipment: A manufacturing firm might lease heavy industrial machinery to use in its operations. If the company is required to assume the responsibilities and risks of ownership under the lease terms – like paying for maintenance and repairs – this lease would likely be classified as a capital lease. The equipment would show up as an asset on their balance sheet, and they would need to account for the depreciation of the machinery over the lease term.
Commercial Real Estate: A retail business might enter into a long-term lease for a storefront. If at any point ownership of the storefront will transfer to the retail business, or if the present value of the lease payments makes up most of the fair market value of the storefront, then this lease agreement would likely meet the capital lease criteria. The business would have to record the storefront as an asset and the lease obligations as a debt on their balance sheet.
FAQs about Capital Lease Criteria
What is a Capital Lease?
A capital lease, also known as a finance lease, is a lease agreement that allows the lessee to use an asset and has the right to purchase it during or at the end of the lease period. The lessee records the asset as its own asset rather than a rental.
What are the criteria for a Capital Lease?
For a lease to be recognized as a capital lease, it must meet at least one of the four following criteria: the lease transfers ownership of the asset to the lessee by the end of the lease term; the lease contains an option to purchase the asset at a bargain price; the lease term is for the major part of the economic life of the asset; or the present value of the minimum lease payments equals or exceeds 90% of the fair value of the asset.
How is a Capital Lease different from an Operating Lease?
A capital lease is different from an operating lease in the accounting treatment. In a capital lease, the lessee records the leased asset as its own asset, while an operating lease is treated like a rental, where the lease payments are considered operational expenses and the asset remains on the lessor’s balance sheet.
What is the impact of a Capital Lease on the balance sheet?
A capital lease affects both the asset and liability sections of a lessee’s balance sheet. The lessee records the present value of the lease payments as an asset and also as a liability. Thus, a capital lease increases both assets and liabilities on the balance sheet.
Related Entrepreneurship Terms
- Present Value of Future Lease Payments
- Ownership Transfer
- Bargain Purchase Option
- Lease Term
- Economic Life of the Leased Asset
Sources for More Information
- Accounting Tools: This website offers a wealth of information on all things related to accounting, including comprehensive explanations on capital lease criteria.
- Investopedia: A comprehensive financial education website that offers detailed explanations and real-world examples on various finance and investment topics, including capital lease criteria.
- Financial Accounting Standards Board (FASB): As the authoritative entity that sets the standards for public and private organizations’ accounting and financial reporting, FASB provides reliable, up-to-date information on capital lease criteria.
- International Financial Reporting Standards (IFRS): This is the official site of the IFRS, a set of international accounting standards stating how specific types of transactions and other events should be reported in financial statements, including guidelines on capital lease criteria.
