Capital lease criteria should be satisfied before calling it a capital lease. The criteria for capital lease revolves around mainly 4 things – ownership, purchase option, the term of the lease, present value of lease rentals.
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Define Capital Lease
In a capital lease, a lessor only finances the asset but the ownership rights reside with the lessee. A capital lease is also defined as the temporary right entitled to a user of an asset. It allows the lessee to records only the interest as expenses.
Capital Lease Criteria
For qualifying as a capital lease, a lease agreement should satisfy any of the four criteria mentioned below:
The term in which the assets are leased out to the user or renter of any asset determine if it is a capital lease or an operating lease. For a lease to be called a capital lease, the leasing period should encompass not less than 75% of the asset useful life, and is not cancellable during this period. This means that the lifespan of the asset to be leased should be greater than it’s already useful life.
Another capital lease criterion is the ownership. Ownership rights in a capital lease are transferred back to the lessee from the lessor when the contacts or agreement expire
Bargain Purchase Option
Bargain option gives the lessee a right to buy the asset from the renter or lessor when the leasing contract or agreement ends. The buying price has to be less than the fair market value at that future date.
The aggregate of present value of each periodic rental (or lease payment) over the lease term should be more than 90% of the market value of the underlying asset at the beginning of the lease.
For example, if the lease rentals of the leased assets whose value is $100,000 are $12,000 every year for say 10 years, the present value of these lease rentals @ 5% would be $92,660.82. We can see that the present value is 92.66% which is more than 90% of the current market value of $100,000. This lease criterion is therefore satisfied for the above lease arrangements.
Therefore, all these listed capital lease criteria are conditions for capital leases and if a lease agreement has any one of these criteria, then the lessee should record the agreement as a capital lease. Otherwise, it is known as an operating lease agreement.
Example of Capital Lease Criteria
Suppose you saw a nice machinery that you would love to own for your business, it has everything you need as an ideal machinery, but the problem is that you don’t have the money to outrightly buy or pay for it. Having a knowledge of capital lease, you contact the owner of the machinery owner to know if he would be willing to finance the purchase of the machinery as long as you agree to make the lease payments. And since you are not willing to return the car after the lease agreement, you can enter what is called a capital lease agreement (which satisfies the criteria explained above) and you take charge of all maintenance, repairs while still paying for your monthly payment depending on the lease agreement.
Capital Lease Criteria FASB
Capital lease criteria according to Financial Accounting Standards Board (FASB) amendment of 2016 asked every corporation operating in the US to capitalize all lease above one year with. This amendment should become effective and fully implemented by December 15, 2018. This capital lease amendment has a serious effect on most corporations in the US. This issue is as a result of GAAP view of the capital lease as a purchase of assets if some criteria are met instead of a rental agreement that it is.
Capital Lease Requirement Disclosures
For a lease agreement to take place, the lessor and lessee are required under the GAAP disclosure form to disclose the following information.
- The general leasing arrangements should be properly described
- There should be a gross amount disclosure of assets and it should be recorded under capital leases.
- The disclosure should also show a major asset class and accumulated depreciation amount.
- There should be a separate identification of the asset obligations. This information is found on the balance sheet of the organization and appropriate classification of the current and noncurrent assets.
- There should be a minimum of all future lease payments for the next five years in total.
- The whole net investment components as of the date of which each balance sheet was presented should show:
- The minimum payment to be received in the future. A number of separate deductions should be made such as representing executor costs, profits that are in the minimum lease payments
- It also shows the minimum lease payments receivable for uncollectible accumulated allowances.
- The benefits (unguaranteed) accruing to the lessor should be disclosed
- Unearned income included offsetting the direct cost that is initially charged against the income for the different period with respect to the presented income statement.
Accounting for Capital Leases
A capital lease which is an example of accrual accounting requires a company to calculate its present value of all the capital lease payment on their yearly financial report. An example is a company estimate value of its capital lease to be $200,000; it records $200,000 debit entry and 200,000 credit entry to its fixed asset account and capital lease liability account respectively on the balance sheet. Since this type of lease is a financial arrangement, the company breaks down its periodical lease payments into expenses. If the company makes $2,000 in its monthly payment of lease and $400 estimated interest rate. This will show a $2,000 credit entry and $400 to the cash account and debit entry to interest expense account respectively. This will then give the company a $1600 debit entry into capital lease account.1,2