Loading the player...

What is a 'Capital Lease'

A capital lease is a contract entitling a renter to a temporary use of an asset, and such a lease has economic characteristics of asset ownership for accounting purposes. The capital lease requires a renter to add assets and liabilities associated with the lease if the rental contract meets specific requirements. In substance, a capital lease is considered a purchase of an asset, while an operating lease is handled as a true lease under generally accepted accounting principles (GAAP).

BREAKING DOWN 'Capital Lease'

In 2016, the Financial Accounting Standards Board (FASB) made an amendment to accounting rules requiring companies to capitalize all leases with contract terms above one year on their financial statements effective Dec. 15, 2018. Even though a capital lease is a rental agreement, GAAP views it as a purchase of assets if certain criteria are met. Unlike operating leases that do not affect a company's balance sheet, capital leases have a profound effect on companies' financial statements and influence how payments under capital leases are broken down into interest and depreciation expenses.

Conditions for Capital Leases

To qualify as a capital lease, a lease contract must satisfy any of the four criteria. First, the life of the lease must be 75% or greater of the asset's useful life. Second, the lease must contain a bargain purchase option for a price less than the market value of an asset. Third, the lessee must gain ownership at the end of the lease period. Finally, the present value of lease payments must be greater than 90% of the asset's market value.

Accounting for Capital Leases

A capital lease is an example of accrual accounting's inclusion of economic events, which requires a company to calculate the present value of capital lease payments on its financial statements. For instance, if a company estimated the present value of its obligation under a capital lease to be $100,000, it then records a $100,000 debit entry to the corresponding fixed asset account and a $100,000 credit entry to the capital lease liability account on its balance sheet. Because a capital lease is a financing arrangement, a company must break down its periodic lease payments into interest expense based on the company's applicable interest rate and depreciation expense. If a company makes $1,000 in monthly lease payments and its estimated interest is $200, this produces a $1,000 credit entry to the cash account, a $200 debit entry to the interest expense account and a $800 debit entry to the capital lease liability account.

A company must also depreciate the leased asset that factors in its salvage value and useful life. For example, if the above-mentioned asset has a 10-year useful life and no salvage value based on the straight-line method, the company records an $833 monthly debit entry to the depreciation expense account and a credit entry to the accumulated depreciation account. When the leased asset is disposed of, the fixed asset is credited and the accumulated depreciation account is debited for the remaining balances.

RELATED TERMS
  1. Operating Lease

    A contract that allows for the use of an asset, but does not ...
  2. Capitalized Lease Method

    An accounting approach that identifies a company's lease obligation ...
  3. Closed-End Lease

    A rental agreement that puts no obligation on the lessee (the ...
  4. Leasehold

    An accounting term used to classify an asset on a company's balance ...
  5. Lease Utilization

    A financial ratio that measures how much a company uses leasing ...
  6. Bargain Renewal Option

    A clause in a lease agreement that gives the lessee the option ...
Related Articles
  1. Investing

    How Does an Operating Lease Work?

    Operating lease is a term used mostly in accounting to denote a lease that gives the lessee rights to use and operate an asset without ownership.
  2. Managing Wealth

    What is a Capital Lease?

    A lease considered to have the economic characteristics of asset ownership.
  3. Investing

    Uncovering Hidden Debt

    Understand how financing through operating leases, synthetic leases, and securitizations affects companies' image of performance.
  4. Personal Finance

    Is There a Way to Get Out of Your Car Lease Early?

    For those who no longer want their car for whatever reason, transferring the lease to an interested party can be a particularly appealing choice.
  5. Personal Finance

    When Is Buying A Car Better Than Leasing?

    People who lease a car are often more concerned with the short-term picture.
  6. Managing Wealth

    When Is Leasing A Car Your Best Bet?

    Leasing a car isn't right for everyone. But it's attractive for those who want low initial payments and the ability to get a new vehicle every few years.
  7. Retirement

    Retirees: Should You Buy or Lease Your Car?

    To buy or lease – that is the question. For retirees, access to safer cars, comprehensive warranties and tax deductions may drive up leasing's appeal.
  8. Managing Wealth

    Why You Should Buy A Car Instead Of Leasing

    While leasing has certain advantages, buying a car tends to save you money in the long run and offers greater flexibility.
  9. Investing

    New Wheels: Lease Or Buy?

    These two major ways to obtain a car have very different advantages and drawbacks. Find out which is best for you.
  10. Personal Finance

    Auto Leasing Hits Record High in Q4

    Auto Leasing is continuously growing in popularity as a preferred choice of financing.
RELATED FAQS
  1. Why might a bond agreement limit the amount of assets that the firm can lease?

    Bond covenants can limit the amount of leases a company can have because leasing contracts are a form of debt. Taking on ... Read Answer >>
  2. You are currently reviewing the following information for JKL Corp ...

    Free info on financial certification exams including study guides, exam questions, and much more! Read Answer >>
  3. At the beginning of the year, HIJ Corp. began to lease new equipment ...

    The correct answer is: b) Total Lease Payment = Interest expense + Principal repayment Step 1: Interest expense = 8.5% of ... Read Answer >>
  4. At the beginning of the year, ABC Corp. began to lease a major piece of equipment ...

    The correct answer is: A) Under the capitalized lease method, the lessee must treat the asset as if it was purchased with ... Read Answer >>
  5. How have low interest rates affected lease rates in the automotive sector?

    Find out how and why lower interest rates for leasing new automobiles have helped spur more consumers to lease cars instead ... Read Answer >>
  6. What are the differences between single, double and triple-net leases?

    Learn the ins and outs of net lease agreements, including the key differences between single net, double net and triple net ... Read Answer >>
Hot Definitions
  1. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  2. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  3. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  4. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  5. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  6. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
Trading Center