What Is a Capital Lease?
Let me explain what a capital lease is directly to you. It's a contract where you, as the lessee, get to use an asset, but it transfers most of the ownership benefits and risks from the lessor to you. To count as a capital lease, the agreement has to meet at least one key criterion, like transferring ownership at the end, giving you an option to buy it cheap, covering most of the asset's economic life, or having payments that match the asset's fair value closely. If it does, you account for it as if you own the asset.
Understanding Capital Lease
You need to understand that a capital lease means you record the asset and the liability on your balance sheet if it fits the criteria. I see it as essentially a purchase under GAAP, unlike an operating lease which is just a rental. This affects your financials through interest expense, depreciation, assets, and liabilities. Back in 2016, the FASB changed rules so all leases over a year get capitalized, effective from late 2018 for public companies and 2019 for private ones. This stopped companies from hiding debt with operating leases. In 2021, they updated it again for lessors with variable payments to classify some as operating if it'd cause a selling loss.
Key Criteria for a Capital Lease
- The lease term is 75% or more of the asset's useful life.
- It includes a bargain purchase option for less than fair market value.
- Ownership transfers to you at the end.
- Present value of payments is over 90% of the asset's market value.
Capital Leases vs. Operating Leases
Let me contrast this with operating leases for you. An operating lease lets you use the asset without any ownership rights. It used to be off-balance sheet, helping companies keep debt ratios low, but ASU 842 changed that starting in 2018-2019, so now you record right-of-use assets and liabilities. To be an operating lease, it can't meet those four capital lease criteria I mentioned. If it does, it's capital. The IRS might even reclassify it to deny deductions and boost your taxes.
Accounting for Capital Leases
When accounting for a capital lease, you calculate the present value of the obligation and put it on your statements. For instance, if it's $100,000, debit fixed assets and credit the liability. Then, break payments into interest and principal—say, $1,000 monthly with $200 interest, you debit interest expense $200, debit liability $800, credit cash $1,000. You also depreciate the asset over its life, like $833 monthly for a 10-year asset with no salvage value, debiting depreciation expense and crediting accumulated depreciation. At disposal, clear out the accounts.
Frequently Asked Questions
You might wonder about examples: say you lease machinery for 10 years out of its 12-year life with a cheap buy option—that's a capital lease. The four criteria are as I listed: 75% life, bargain option, ownership transfer, or 90% value. On taxes, you can deduct the interest part and depreciate the asset, unlike full deductions on operating leases.
The Bottom Line
In summary, a capital lease puts ownership-like responsibilities on you, recording it as an asset purchase on your balance sheet if it meets the criteria. It affects your interest, depreciation, and taxes differently from operating leases. I recommend consulting a tax advisor for your specific situation.
Other articles for you
Net receivables represent the money a company expects to collect from customers after accounting for likely uncollectible amounts.
This text is an overview of liability insurance topics from Investopedia, covering basics, types, and related financial protections.
Economic stimulus involves government actions through fiscal and monetary policies to boost private-sector activity and economic growth.
A non-conforming mortgage is a home loan that doesn't meet GSE guidelines and can't be sold to Fannie Mae or Freddie Mac, often leading to higher interest rates.
The Fisher Transform Indicator normalizes asset prices to highlight turning points and trends in technical analysis.
Inventory management involves overseeing the ordering, storing, and selling of a company's raw materials, components, and finished products to avoid shortages and overstocking.
A job lot is a smaller-than-standard commodities futures contract or a non-standard manufacturing job.
A billing cycle is the time interval between billing statements for recurring goods or services, typically monthly but variable.
The National Registration Database is a Canadian electronic system for securities registration that improves efficiency and protects investors.
This text is a comprehensive glossary of financial and economic terms starting with the letter 'O' from Investopedia.