Entangling the process by which to obtain a capital lease can be daunting. The first steps should be focused on understanding the meaning of this particular type of lease agreement.
When one individual or company lends an asset to another, and the two parts exchange money, then we’re dealing with a lease agreement. The vast majority of these contracts are operating leases. Under the general accounting principles, an operating lease handles like a true lease. In contrast, capital leases are considered a fixed-term and usually non-cancelable lease similar to the purchase of an asset through installments.
In this post, we’re going to untangle the technicalities of a lease agreement and forever draw the line between the capital and the operating lease.
Capital Lease Explained: Definition and Criteria
Capital Lease Criteria
A capital lease bears many names such as a financial lease, a buck-out or a dollar-buyout lease. To break down the concept for a bit, let’s list the criteria for a capital lease. If an agreement contains any of the following requirements, then we’re dealing with a capital lease.
- Ownership rights: The title of the asset stays with the lessor – for the time the lessee loans the goods. However, by the end of the lease period, the lessor hands over the ownership of the asset to the lessee. For a nominal fee that can be as little as a dollar. Hence, the ‘dollar-buyout’ witty moniker.
- Term of the lease: The lease agreement is for a period equivalent to or longer than 75% of the estimated useful life of an asset. During that time, you cannot cancel the agreement.
- Bargain purchase option: At the end of the lease agreement, the lessee may purchase the leased asset at a price below its fair market value.
- Present value: This requirement comes into effect at the beginning of the lease term. It practically means the present value of the lease payments is at least 90% of the fair market value of the asset.
All in all, the capital lease is actually a full payment lease, considering the money installments pay back the full cost of the asset. These forms of leases are commonly employed by small businesses who prefer to lease equipment instead of financing it with a term loan demanding huge capital.
However, the definition still seems abstract at this point. To better understand the concept, we have to define it against its opposite. In our situation, stepping through the looking glass of the capital lease world will take us into operating lease territory.
Capital Lease vs. Operating Lease
As mentioned before, the operating lease – or fair market value lease (FMV lease) is the classic kind of agreement where the lessor transfers the right for use – or loans the asset to the lessee for a specified time period. At the end of the operating lease agreement, the asset is returned to the owner. The ‘NO transfer of ownership’ is the main difference between the two kinds of leases.
Furthermore, the period of time to which the lessee is entitled to use the asset has to be shorter than the economic life of the particular asset. This is to ensure the borrower, or the lessor, receives his asset back.
It makes more sense for a company to use an operating lease when it purchases equipment that is high-tech and short-lived, such as software.
How does this difference between the two types of leases translate in accounting terms?
An operating lease is considered a form of renting. Thus, the payments fall into the ‘operational expenses’ category. This means the asset does not appear on the balance sheet. Also, each lease payment will list as an expense. In contrast, a capital lease enters on the balance sheet as being an asset of the lessee.
This year, the Financial Accounting Standards Board initiated an amendment by which it requires companies to account for all lease agreements with terms above one year on their income statements. According to the General Accepted Accounting Principles (GAAP), a capital lease is a purchase of assets. Thus, unlike operational leases who stay off the balance sheet, a capital lease will have a profound effect in terms of interest and depreciation trends.
A statement which leads us to the pros and cons of a capital lease.
Pros and Cons of the Capital Lease
Pros: The lessee can claim a tax deduction on interest on the lease payment each year. Furthermore, the borrower can also record a depreciation charge on the asset if its value decreases in time. This will reduce the amount of the fixed asset in its accounting records.
Cons: On the other hand, as previously mentioned, the asset will stay on the balance sheet. This means the company’s return on investment will be lower.
Capital Lease Accounting
Evaluate and make sure you understand the terms of the capital lease. Follow the four criteria to the word. Particularly, remember that the lease term should be longer than 75% of the asset’s economic life.
According to the GAAP, when you’re making an entry for a capital lease, you have to stick to the same accounting principles that govern the purchasing of an asset. So review the accounting process for recognizing a capital lease.
Record the payment installments. Since you don’t have ownership of the asset yet, after you write the asset on your balance sheet, you also have to add the value of it as a capital lease liability. While the interest you pay for the asset over time records on your income statement as an interest expense, the principal loan will reduce the balance of the liability.
Finally, don’t forget to recognize any depreciation expenses in your journal entry.
Capital Thoughts on the Capital Lease
The capital lease follows a very precise definition. Typically, both parties (the lessor and the lessee) have a handle on the budget, time frame, and future expectations before they sign a lease. Be sure you recognize your needs and opt for the right choice for you. Is it the buck-out lease or the fair market value lease that’s best for you?