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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.

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