Capital lease criteria should be satisfied before calling it a capital lease. The requirements for a capital lease revolve around mainly four things – ownership, purchase option, the term of the contract, and the present value of lease rentals.
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 entitlement to a user of an asset. It allows the lessee to record only the interest as expenses. This is where the lessee is ready to take up all the obligations of the property under consideration as if he owns it. However, due to a shortage of funds, he requests the lessor to finance. In turn, the lessee is ready to pay the capital sum + interest over the useful life of the Asset to the lessor in installments/EMIs.
Capital Lease Criteria
Under ASC 840-25-1, there are four tests to determine whether a lease is a capital lease or an operating lease. This assessment and determination need to be performed while signing the lease agreement. Those 4 test criteria are:
The term for which the assets are leased out to the user or lessee of any asset determines if it is a capital lease or an operating lease. For a contract to be called a capital lease, the leasing period should cover not less than 75% of the Asset’s useful life. Moreover, this arrangement is not cancellable during this period. It means that the lifespan of the Asset to be leased should be higher than its remaining useful life.
Another capital lease criteria are ownership rights. The lease agreement should provide the option to transfer ownership rights to the lessee at the end of the lease term. Under a capital lease, there remains a clear-cut provision for transmission of the ownership rights to the lessee from the lessor at the expiry of the contract.
Bargain Purchase Option
The ownership transfer option is given under the lease to the lessee always remains at a very low/nominal price. We can say that the option price under the arrangement at the expiry of the lease should be a bargain price. Such an 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 the 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, ten 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 with the above lease arrangements.
Therefore, all the above listed four capital lease criteria are pre-conditions for determining and terming the arrangement/lease, whether it is a capital lease or not. If these conditions are satisfied, the lease under question will be classified as a capital lease. And if the lease under question does not meet these criteria, it will be termed as operating the lease agreement.
Example of Capital Lease Criteria
Suppose you saw excellent machinery that you would love to own for your business, it has everything you need as ideal machinery, but the problem is that you don’t have the money to buy or pay for it outrightly. Knowing capital lease, you contact the owner of the machinery owner to see 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 ready to return the car after the lease agreement, you can enter what is called a capital lease agreement (which satisfies the criteria explained above). Depending on the lease agreement, you take charge of all maintenance and repairs while still paying for your monthly payment.
Capital Lease Criteria FASB
According to the Financial Accounting Standards Board (FASB) amendment of 2016, Capital lease criteria asked every corporation operating in the US to capitalize all leases above one year. This amendment should become effective and fully implemented by December 15, 2018. This capital lease amendment has a severe effect on most corporations in the US. This issue results from the 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 occur, the lessor and lessee are required under the GAAP disclosure form to disclose the following information.
- The general leasing arrangements should be adequately described.
- There should be a gross amount of disclosure of assets, and it should be recorded under capital leases.
- The disclosure should also show a significant 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 the 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 and profits 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.
- The unearned income included offsetting the direct cost initially charged against the income for a different period with respect to the presented income statement.
Accounting for Capital Leases
A capital lease, an example of accrual accounting, requires a company to calculate the present value of all the capital lease payments on its yearly financial report. An example is a company that estimates the 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. Suppose the company makes $2,000 in its monthly lease payment and a $400 estimated interest rate. In that case, this will show a $2,000 credit entry and $400 to the cash account and debit entry to an interest expense account, respectively. This will give the company a $1600 debit entry into the capital lease account.