In a capital lease, a lessor only finances the asset, but the ownership rights reside with the lessee. And therefore, another term for a capital lease is finance lease. 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.
Before calling it a capital lease, it should satisfy capital lease criteria. The requirements for a capital lease revolve around five things. These are ownership, purchase option, the term of the contract, present value of lease rentals, and specialized assets.
Capital/Finance Lease Criteria
Under ASC 840-25-1, there are five tests to determine whether a lease is a capital lease or an operating lease. This assessment and determination take place while signing the lease agreement. Those 5 test criteria are:
The period for which the assets are leased out to the lessee determines if it is a capital lease or an operating lease. For a lease to qualify as 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 under lease 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 given under the lease to the lessee always remains at a very low/nominal price. The option price under the arrangement at the expiry of the lease should be a bargain price. Such an option gives the lessee the right to buy the asset at the end of the leasing agreement. 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, consider an asset worth $100,000 to be leased for ten years. If the lease rentals of the leased assets are $12,000 every year, 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.
Specialized Asset – Introduction of 5th Criteria – ASC 842
Over the years, the nomenclature of capital lease is now changing to finance lease. Because in most such cases, though, all the risk of the assets lies with the lessee; however, funding is provided by the lessor. And the lessor gets the funding back in the form of lease rentals, which comprises the principal and an interest portion. Secondly, in most cases, the lessee ultimately buys the leased asset at a bargain value compared to the fair market value.
Considering the above situation, ASC 842 has added one more important criterion to define such leases as a finance lease. Therefore, the 5th criterion is:
The leased asset should be special or unique in nature. And such an asset will not be of any value to the lessor at the expiry of the lease term.
Therefore, all the above listed five capital lease criteria are pre-conditions for determining and terming the arrangement/lease, whether it is a capital lease or not. If the lease agreement satisfies these conditions, the lease under question will classify 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 into 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 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 have become effective and fully implemented from 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 need to disclose the following information under the GAAP disclosure form.
- Adequate description of the general leasing arrangements.
- 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 on 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.
- Disclosure of the benefits (unguaranteed) accruing to the lessor.
- The unearned income included offsetting the direct cost initially charged against the income for a different period with respect to the presented income statement.